A1)

With the financial statements of Apple showing improvements year over year and with the high
returns on investments made, it can be said that despite being in the market for quite some time
Apple is still growing at a high rate. The stock of Apple has been consistently beating the S&P Index
and yielding high returns to the investors. Over the years after establishing a goodwill in the market,
it can be seen that Apple has been improving upon their profitability with giant leaps in their
margins. Having a high cash balance is a major benefit as it gives stability to the operations of the
company and especially if one is involved in high cost products. Having no leverage saves them from
any repayment liabilities and establishes a strong position in the market. Overall, it can be said that
Apple has been setting new benchmarks in the market being a topper in the industry charts and also
it is needless to say that it is financially strong and capable of handling their operations.

A2)

The risk factors which are likely to have a major impact on Apple’s future business and future
outlook are listed below:

 Innovation: Whist enjoying the continued success in the market with constant
breakthroughs in technology and new innovative products, it will always be a challenge to
the changing needs of the consumers. If Apple doesn’t move with the market in their
innovation it may lead to a risk of being obsolete.
 Market Competition: While the increasing trends towards digitization helps in expanding
the market but the major threat it comes along with is the threat of new entrants in the
market. Increase in market players will not only affect the market share but also hamper the
overall market dynamics which may lead to all kinds of problems for Apple.

A3)

With the tax strategies followed by Apple, they have managed to save a major chunk of their
earnings. The strategies allowed their effective tax rate to lower down to around 25% in comparison
to the federal rate of 35%. All of this started in 2006 where Apple set up their cash-management
subsidiary in Reno, Nevada where Apple enjoyed the benefit of not paying the corporation nor the
capital gain tax which helped them evade the 8.84% Californian tax.

Having following the ‘Double Irish With a Dutch Sandwich’ policy wherein they benefit from reducing
their tax burden by directing around 1/3 rd of their total profits to Ireland and other manoeuvres
which included their major iTunes sales taking place at Luxembourg. All of these strategies helped
them generating 70% of their profits from abroad and bring their effectively paid cash tax rate to
9.8% compared to the industry average of 24%.

A4)

From the case the following information was determined:

a) Given the rate of return of the 10 year treasury bonds in 1.8%, it was taken to be as the risk
free rate since the rate of default is extremely low.
b) The market risk premium and the value of Beta was already mentioned in the case.

Given the above information it was possible to find out the cost of equity or Ke of Apple. The value
of Ke was 7.65% while the actual return on equity for the year was 47.17% before tax and 35.3%
after tax. A clear conclusion can be made that since the return on equity is higher than the cost of
equity, so we can consider that the stock price of Apple is undervalued. However, the area where
the major problem lies is that the Standard Deviation of the stock is not considered or in other words
only the systematic risk is considered in the valuation process using CAPM. Apple being in the
technology industry will have high risks and not taking that into consideration will lead to
inaccuracies in our process thus even though the CAPM method suggest that the stock price of Apple
is undervalues but we cannot solely reply on this process to get a good overview of the matter.

A5)

As far as the technology industry come to picture, it is not generally considered that the
shareholders will get dividends and rather the shareholders expect that the company would put it to
use for research and development activities and expect to make profits through capital gains. Taking
the example of Microsoft, when they had huge cash piles they eventually declared dividends which
did not have that good an impact on the market mainly because of the stereotype that they don’t
want to reinvest in their business and grow. Apple has a similar situation wherein they have a
massive cash balance and they have an option to declare dividends. But in my opinion it doesn’t
come at the expense of the shareholders. The shareholders have enjoyed significant gains over the
years with Apple’s stock performing way better than S&P. Along with that it is also necessary for
Apple to keep some cash balances as they are into high cost business which allows them to be free
and reduce their risks.

A6)

Apple even though had been in the market for quite some time had been growing like a start-up
even at the present. What is meant by this is that Apple was still a growing company and was still
away from maturity despite their age. Given that they had huge cash reserves it wasn’t unnatural for
the shareholders to wait for dividends but at the same time when they declare dividends it is a
symbol that they are probably running out from growth opportunities. Apple were hoarding cash at
a high rate and there was only a single risk that was slowing down. Keenly aware of the facts and the
consequences they proposed a dividend strategy that included buying back of shares which will not
stop the cash building process but instead just slow it down.

In my opinion, the new Apple dividend pay-out policy is better as it suits the shareholders better as
we see the impact of the same in the markets as well. Even after satisfying their shareholders they
have enough cash balances to fund their innovation needs and to further nurture the growth of the
company. If they hadn’t declared dividends, they would have even high unnecessary cash balances
which would have created a bad reaction in the mind of the shareholders. The pay-out ratio was
close to the average but although could be looked upon to get near the likes of Microsoft or even
Walmart which would make the stock more attractive for the investors.

A7)

From the year 2003 we see that Apple boasted about being a debt free company with zero long term
debt. It was seen that Apple had capital structure with a mix of debt, common equity and
convertible preference shares till the year 2002. With the major expansion and the developments in
the business it was seen that Apple had soon paid off all their debts and had relied on the cash
generated from their activities and their retained earnings to fund their day-to-day activities. With
reference to the MM theory, in the case of Apple it can be said that the cost of equity should be low
as they have been debt free since a long time. They will have a low rate as they cost of equity will be
directly proportional to the leverage and since the risk of the equity shareholders has reduced, it will
have a direct impact on the cost of equity. Being a debt free firm it is advantageous to Apple to save
them from any interest expenses that may eat up their profits and also gives them flexibility over the
dividend decisions. With less liquidation risks, shareholders enjoy a comfortable position in the
market and also tend to respond positively to market changes which is a win-win situation for both
the parties.

A8)

Following were the Assumptions made before computing the changes in the balance sheet:

a) Tax wasn’t considered to be a part of the market for the purpose of calculations
b) The interest rate when issuing debt was considered to be 10%, which meant that the
interest was 4 million (10% of 40 million)
c) It is assumed that the stock price remains unchanged.

As it can be seen that the total value of the capital structure doesn’t change as the common stock
and debt issued are equal regardless the mode selected to raise money. The only difference is that
the profitability is through the tax shield benefits that the company can enjoy. On the other hand
since Apple has enough cash balance to fund their project they can consider equity as they will lower
their cost of capital and also remain debt free.

A9)

The question is based on the following assumptions (for calculation purposes):

a) The tax rate is assumed to be 25.2%.

b) The bond rating of AAA is assumed to be 6%
c) The rate of interest is assumed to be 10%.
d) The EBIT for calculation is 10 and the loan taken is 40.

Now in the calculations we see that due to the amount of the debt raised the bankruptcy cost is
managing to negate the effects of the tax shield benefits and on top of that is contributing in the
decrease in the overall value of the firm. With respect to the Trade-Off Theory we can clearly see
that the benefits are being overpowered by the cost burden of the debt raised.

In other words, MB of Debt < MC of Debt.

A10)

For the scenario wherein there is an optimal equity structure for Apple, the figures were assumed.
Given below are the assumptions made for the purpose of calculations:

a) The EBIT was considered to be 10,000.

b) The Cost of Equity was considered to be 10%
c) The Tax rate was assumed to be at 20%
d) The Cost of Debt was assumed to be 29%
e) And the Debt for leverage is assumed to be amounting to 5,000.

Given that (1-Tc)*(1-Te) was greater than (1-Td), it was clear that the Cost of leverage is going to
outweigh their benefits. The calculations proved the former with the value of unlevered firm being
greater than the value of the levered firm. Thus, it was proved with the relation of the corporate and
the personal taxes which capital structure is better in the example.

A11)
As on 2010, Tim Cook received a total compensation of $59 million, having a base salary of $800k
compared to just $1 of Steve Jobs. Along with the base salary Tim received a bonus of $5 Million and
stock awards amounting to $52.3 Million. By 2011, Tim was had one of the highest pay packages
with a total compensation of $378 Million. It included 1 million restricted Apple shares which will
Vest in 5 years and the remaining amount in the next 10 years.

Apple’s main target markets remained the same with the company sharing the same vision that Jobs
has which was to “Stay Hungry and Stay Foolish.” Employees were encouraged to innovate
continuously and create a difference in the industry.

A12)

With the help of online resources and the data mentioned in the case it was possible for me to make
a portfolio that yielded higher return at a comparatively low risk than that of Apple thereby making
it a good investment option. In order to diversify the portfolio a stock with relatively low correlation
with Apple was chosen. Procter and Gamble was the stock other than apple wherein half of the total
investment was to be made with the main reason being that it helped us in adding some stability in
the portfolio as it has operations at different segments thus reducing the risk.

A13)

It can be observed that when the correlation is 0 the risk is lower and when the correlation is 1 the
risk is high. It can be explained as when the correlation is 1 it signifies that the stocks move together
to any market changes and vice versa.

A14)

Analysis of Case 1:

As seen in the case the value of the unlevered firm is $200 million and the value of levered firm is
$176 million. Given that value of unlevered firm is greater than the value of levered firm, we can say
that we can benefit from arbitrage with MM Theory’s proposition 1 in place. Provided that the
unlevered firm is more expensive than the levered firm, we can assume a short position for the
shares of unlevered firm and assume a long position for the shares and debt of the levered firm and
benefit from the price difference. After checking with the calculations it can be said that there is a
profit of $2.4 million if the arbitrage option is followed.

Analysis of Case 2:

As seen in the case the value of the unlevered firm is $200 million and the value of levered firm is
$225 million. Given that value of unlevered firm is lesser than the value of levered firm, we can say
that we can benefit from arbitrage with MM Theory’s proposition 1 in place. Provided that the
unlevered firm is cheaper than the levered firm, we can assume a long position for the shares of
unlevered firm and assume a short position for the shares and debt of the levered firm and benefit
from the price difference. After checking with the calculations it can be said that there is a profit of
$2.4 million if the arbitrage option is followed.