Investment Analysis Paper on Apple Inc.

Elijah Clark

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Investment Analysis Paper on Apple Inc.

Apple Inc. (Apple) is a registered publicly traded company established in 1977 and is

currently headquartered in Cupertino, California (Apple Inc., 2015a). The company’s products

and services include mobile communication and media devices, portable digital music players,

personal computers, software, accessories, services, networking solutions, and third-party digital

content and applications. The company sells its products and digital services worldwide through

online media, direct sales force, retail stores, through third-party wholesalers, and cellular

network carriers. The company sells directly to consumers, small and mid-sized businesses,

educational institutions, enterprises, and government agencies. The company’s operations are

based in the Americas, Europe, Greater China, Japan, and retail. In 2014, the company’s direct

and indirect distribution sales channels accounted for 28% and 72% of total net sales (Apple Inc.,

2015a). The unit sales, which consisted of the iPhone, iPad, Mac, and iPod products, was

270,446 million units total within the company’s fiscal year (Apple Inc., 2015a).

Board of Directors

The 2015 proxy statement of Apple stated that the company annually selects its board of

directors, which currently has 10 board members (Apple Inc., 2015a). Shareholders elect board

of directors and the Board periodically reviews the structure of leadership (Apple Inc., 2015a;

Ross, Westerfield & Jaffe, 2013). The Apple proxy includes the biographical details including

qualifying skills, qualities, attributes, and experience of each nominee (Apple Inc., 2015a). The

proxy also contains information regarding how the Board member selection takes place (Apple

Inc., 2015a).

Monitoring Potential of the Firm's Board of Directors

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The Board consists of a diverse group of leaders with backgrounds in senior leadership,

finances, compliance, and risk management. With the exception of the CEO, all Board members

are independent under the rules of NASDAQ and SEC (Apple Inc., 2015a). The Board

committees include: (a) Audit and Finance Committee, responsible for overseeing accounting,

and reviewing financial transactions and risk management (Apple Inc., 2015a); (b)

Compensation Committee, responsible for analyzing compensation arrangements for the

executive officers, CEO, and Board (Apple Inc., 2015a); (c) Nominating Committee, responsible

for assisting the Board in making recommendations concerning members, processes, and

overseeing corporate governance (Apple Inc., 2015a); and (d) Governance Committee, which

advise and recommend matters to the board of directors.

Strengths and Weaknesses of Board Structure

Though Apple does have a Governance Committee in place, the board of directors has

strengths and weaknesses. From the perspective of the Audit Committee, it has a primary

responsibility to oversee risk management at the enterprise level (Apple Inc., 2015a). Having the

Audit Committee only monitoring the enterprise level leaves the Nominating Committee and

Compensation Committee responsible for managing their audits. It would be beneficial to have

the Audit Committee oversee all company audits so that there are no ethical concerns within

each department.

Ethical Concerns

Apple manufactures many of its products in countries with differing labor standards

where the company has less direct oversight (Apple Inc., 2015a). To solve this, Apple’s

corporate governance provides national and international employees with a Business Conduct

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Helpline to report misconduct to the Audit Committee and Finance Committee (Apple Inc.,

2015a). Apple encourages ethical behavior by providing its employees, officers, and Board with

a code of ethics (Apple Inc., 2015a). The code is available on the company’s website.

Competitive Financial Ratio Comparison

Apple’s major competitor is Microsoft Corp. (Microsoft). Microsoft offers products

including operating systems for computing devices, servers, phones, video games, online

advertising, software, management tools, and other intelligent devices (Microsoft Corporation,

2014). Apple and Microsoft are publicly traded companies and compete within similar markets

(Apple Inc., 2015a; Microsoft Corporation, 2014). The selected financial ratio comparison in

Table 1 shows the annual financial statements of Apple (Apple Inc., 2015a) and Microsoft

(Microsoft Corporation, 2014).

Table 1

Apple and Microsoft Selected Financial Information for 2014, 2013, and 2012 (in millions)

Apple Year 2014 Year 2013 Year 2012

Net income $39,510 $37,037 $41,733

Revenue $182,795 $170,910 $156,508

Assets $231,839 $207,000 $176,064

Equity $111,547 $123.549 $118,210

Microsoft Year 2014 Year 2013 Year 2012

Net income $22,074 $21,863 $16.978

Revenue $86,833 $77,849 $73,723

Assets $172,384 $142,431 $131,271

Equity $89,784 $78,944 $66,363

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DuPont Identity

The DuPont identity is a financial statement comparison that evaluates ratios of

accounting numbers (Ross et al., 2013). The DuPont breakdown calculations help determine the

potential value of the organization based on the annual financial performance (Ross et al., 2013).

The DuPont identity allows for the examination of how profit margins, asset turnover, and equity

multiplier affect return on equity (ROE) (Ross et al., 2013). The calculation used to determine

the DuPont identity is profit margins times total asset turnover times equity multiplier equals

ROE (Ross et al., 2013). Table 2 shows the DuPont identity of Apple and Microsoft over the

previous three years.

Table 2

Apple and Microsoft DuPont Identity for 2014, 2013, and 2012

ROE % Profit Margin %

AssetTurnover

EquityMultiplier

Apple Year 2014 35.42% 21.61% .79 2.08

Year 2013 29.98% 21.67% .83 1.68

Year 2012 35.30% 26.67% .89 1.49

Microsoft Year 2014 24.59% 25.42% .50 1.92

Year 2013 15.35% 28.08% .55 1.80

Year 2012 14.00% 23.03% .61 1.83

Differences and Trends

The profit margins for Apple have held relatively steady between 2013 and 2014 at

21.67% and 21.61%. Profit margins for Microsoft have fluctuated with 23.03% in 2012, 28.08%

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in 2013, and 25.42% in 2014. The equity multiplier at Apple has increased from 1.49 in 2012 to

2.08 in 2014. In addition, the company shows a decrease in profit margins, which align with

asset turnover (see Table 2). There are positive revenue increases within both Apple and

Microsoft year over year, which correspond with the growth in assets (see Table 1). Microsoft

has seen a positive trend between net income, revenue, assets, and equity, in addition to an

increase in ROE over the past three years from 14.00% in 2012 to 24.59% in 2014. Furthermore,

Microsoft has had significantly better profit margins than Apple between 2013 and 2014, with a

difference of 6.41% in 2013, and 3.81% in 2014 (see Table 2).

Growth

A dividend growth model analyzes companies that pay dividends under three conditions:

zero growth, differential growth, and constant growth (Ross et al., 2013). Organizations such as

Apple, which has corporate governance, often payout larger dividends than smaller firms

(Adjaoud & Ben-Amar, 2010). Apple has maintained a quarterly dividend payment at $0.47

current regular average per stock share in 2014 (see Table 3). The growth model uses the present

value of dividends to determine its future stock price (Ross et al., 2013). The derived stock price

would be sensitive to the applied discount rate if the dividend growth model zero growth sub-

models would remain constant (Ross et al., 2013).

Dividend Growth Model

The dividend growth model estimates future dividends as reflected in the stock

value based on the present value of those stocks (Ross et al., 2013). The growth rate of an

organization's stock reflects its earnings and dividends. Apple's quarterly dividends have

been constant at $0.47 for the year of 2014 (see Table 3).

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Table 3

Dividend and Stock Price Raw Data for Apple (in millions, except per share amounts).

Apple Year 2014

Net income $ 39,510

Equity $ 111,547

Total dividends paid $ 11,126

Outstanding shares 5,826

Earnings per share (EPS) $ 6.78

Dividends paid per share $ 1.91

Stock price as of 31 Dec 2014 $ 112.82

The overall growth rate needed to calculate the constant growth rate of dividends

uses the formula:

P= ¿k−g

( 1 )

P is the common stock investments present value. Div represents the per share dividends

expected to be paid one year from the day. The denominators k and g show the firm’s growth

rate. K is the required rate of return for equity investors, and g is the growth rate in dividends.

The formula necessary to determine the value of g is:

g = Retention ratio × ROE ( 2 )

The retention ratio is the percentage between generated and retained earnings (Ross et al.,

2013). ROE is an estimate that represents the historical ROE for the organization. The earnings

growth rate based on the assumption of a constant earnings ratio, determine the dividend growth

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rate (Ross et al., 2013). The retention ratio is necessary for determining the growth in earnings.

The formula used for calculating the retention ratio is:

Retention Ratio=Net Income−DividendsNet Income

( 3 )

Apple’s total dividend amount paid in 2014 is $1.91 per share, and the net income is

$39.51 billion (see Table 3). The retention ratio for Apple is .72 (see Table 4). The

organization’s equity is $111,547 (see Table 3). The ROE is 35.42% as determined by the

formula:

ROE=Net IncomeEquity

( 4 )

In 2014, Apple's earnings growth rate was 25.45% (see Table 4). Consequently, the

growth results showcased present a feasibly expected growth rate for the organization.

Table 4

Growth Rate for Apple

Analysis Formula Year 2014

ROE Net income / Equity 35.42%

Retention ratio 1 – (dividends / net income) .72

Earnings growth rate Retention ratio x ROE 25.45%

Price to earnings ratio Market value per Share / Earnings per Share

19.37%

Issues with Using the Growth Model

Utilizing a growth model requires an enormous amount of speculation to forecast future

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dividends. In the case of Apple, while the company has been providing a constant and positive

dividend payout, it has only been steady and constant since 2013. Predicting the future value of

the dividend can be tricky considering Apple’s scattered dividend payout history. The company

constantly began paying quarterly dividends in May of 1987 until November of 1995 (Apple

Inc., 2015b). Between 1995 and 2013, there were only two payout periods, which were in 2012

(Apple Inc., 2015b). The growth model does not predict whether this non-paying growth gap will

occur again.

Reasonableness of Constant Growth

The dividend discount model according to Foerster & Sapp (2005) is unique from the

dividend growth model. In addition, the Gordon growth model and dividend discount model

constant growth sub-model have indistinguishable formulas (Foerster & Sapp, 2005; Ross et al.,

2013). As a result, the dividend growth model and dividend discount model formulas are unique

(Foerster & Sapp, 2005; Ross et al., 2013). By calculating the dividend growth model and

dividend discount model, Apple will continue at a constant growth within the coming years.

Annual Report

The company believes that research and development (R&D) along with marketing and

advertising (M&A) are critical to the development and sale of its products and technologies

(Apple Inc., 2015a). To satisfy the consumers, the company uses a growth strategy that targets

individuals, businesses, enterprises, educational institutions, and government agencies (Apple

Inc., 2015a). Apple is operationally an industry leader in product innovation, consumer loyalty,

and brand awareness. Apple’s competitors are exploring similar growth strategies by providing

products and services at little profit, no profit, or even at a loss in order to compete with the

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company’s offerings (Apple Inc., 2015a).

The company’s future financial condition and operating results are dependent upon the

company’s ability to ensure a continual and timely flow of competitive products, services, and

innovative technologies (Apple Inc., 2015a). Projects focused on mobile communication, media

devices, personal computers, software, and accessories create real options that have an impact on

the company’s financial health (Ross et al., 2013).

Potential Real Options

There are real options available that support Apple with its strategic growth strategy. The

influence of information technology has tremendously affected the business sector (Mukherji,

2002; Kotler & Keller, 2012). Demand for innovation technology, rising competition, and rapid

technological advances are the primary drivers behind the technology industry (Mukherji, 2002).

At Apple, technology leverages the company’s ability to create unique and innovative

technological products and services. Within the highly competitive information technology

industry, Apple has room for growth by concentrating on constantly growing sectors such as

mobile communication, media devices, personal computers, software, and accessories (Apple

Inc., 2015a).

Real options and adjustments occur when new projects such as computer platforms,

mobile devices, and software have altering possibilities to adjust as technology and market

conditions change (Ross et al., 2013). Apple can utilize real options during a project to determine

an effective and strategic direction for the success of the project (Ross et al., 2013). The real

options available to Apple include expansion, abandonment, and timing opportunities for active

projects (Ross et al., 2013). Apple is committed to satisfying the consumer product and

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technology demand by creating new and innovative products (Apple Inc., 2015a). Consequently,

the company has continued to implement real options by extending its partnerships with digital

content providers, and expanding its online and retail facilities to reach effectively more

customers (Apple Inc., 2015a).

Capital Budgeting Process

Based on the size of Apple, the chief financial officer does not have the authority

individually to approve capital budgeting projects regarding the company's long-term objectives

(Apple Inc., 2015a). Specifically, the Audit Committee and Finance Committee are responsible

for overseeing and approving the company’s large financial transactions and enterprise risk.

Additionally, the Compensation Committee determines the grant and bonus amount distributed

to the company’s executive officers. Its Audit Committee, Finance Committee, and Risk

Oversight Committee govern the company’s investment activities, which include key members

of management (Apple Inc., 2015a; Ross et al., 2013).

Beta

Beta is a volatility measurement of a stock mutual fund or exchange traded funds

(Radović & Aleksandar, 2012; Ross et al., 2013). Beta measures the responsiveness of a stock’s

return to the market’s return. Additionally, beta measures a security’s systematic risk sensitivity

and is determined by a firms’ characteristic (Radović & Aleksandar, 2012). The average beta is

1.0, and a stock with a beta of 1.0 moves precisely with the market (Ross et al., 2013). A higher

than average beta represents a greater degree of rising and falling. In contrast, a beta lower than

1.0 indicates an active security’s price that will rise and fall less. Using beta is more reliable

when being applied to a portfolio of companies. Industry beta reduces estimation error when

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determining if a firms’ operation is similar to industry operations. In regards to Apple, the beta

coefficient is 0.94 as of December 31, 2014 (Reuters, n.d.); which indicates a lower risk factor if

held within a well-diversified portfolio (Ross et al., 2013). Considering Apple has a beta

coefficient of less than 1.0, it is less volatile than the general market.

Expected Return – CAPM

Capital asset pricing model (CAPM) represents the implied expected return on a security

in relation to its beta (Ross et al., 2013). CAPM calculates the required rate of return for risky

assets. The required rate of return is the increased expected value based on inherent risk of

assets. The formula for CAPM is:

R s=Rf + β × ( Rm−R f ) ( 5 )

The Rs variable is the expected return; Rf represents the investor rate if they were to

invest money risk-free; β is the beta of security; and Rm and Rf are the differences between the

expected market return and the risk-free rate (Ross et al., 2013). invest. The United States

Treasury 52 week bill rate was .22% as of December 31, 2014 (U. S. Department of the

Treasury, 2015). To find the expected rate of return, the formula is:

Rm=Rf +Risk premium ( 6 )

Rf represents the risk-free rate, and Rm represents the expected return. According to Ross

et al. (2013), the average historical equity premium is 6.9%, so 7% or .07 is an estimate for the

equity risk premium. The expected market return value is .0722, calculated from .0022 + .07.

The CAPM is .0659, as determined by calculating .0022 + .94 x (.0700 - .0022). The expected

rate of return for Apple is 6.59%.

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Dividend Growth Model versus CAPM

CAPM and dividend growth model (DDM) are prominent models used for evaluating

potential investments. CAPM is used to evaluate whether an investment can grow by considering

risk and comparing to market averages. DDM uses detailed financial projections to measure the

value of future dividends to determine the stock value (Ross et al., 2013). CAPM is valued based

on the calculated beta, risk-free rate, and market return rate (Ross et al., 2013).

In regards to Apple, the estimated growth rate in earnings is 25.45% (see Table 4). Given

a $1.91 total dividend for 2014 and a $112.82 price per share as of December 31, 2014; the

discount rate for Apple is 27.14% according to the formula:

R s= ¿P

+g ( 7 )

Rs is the discount rate or cost of equity (Ross et al., 2013); Div is the estimated dividend per

share to be received next year; P is the stock share price; and g is the constant expected growth

rate in dividends.

To find the expected rate of return for a stock or portfolio, CAPM is a useful tool. DDM

fails to consider risk directly, while the CAPM is a matter of restrictive assumptions. The

advantage of CAPM is that it looks at more factors than DDM when determining the value.

Considering both CAPM and DDM rely on future assumptions, neither is considered a perfect

investment tool.

Debt and Equity

Determining the company debt, equity, and weighted average cost of capital (WACC)

helps determine stock research and provides details into the returns shareholders should expect in

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the long-term. WACC is the minimum return that company’s need in order to satisfy investors.

Additionally, knowing the company’s equity and debt gives insight into what is needed for the

company to break even on its investments. The two types of capitals include debt and equity.

WACC is used by companies to determine the cost necessary to raise capital through debt and

equity. The capital structure that produces the highest firms value is the one in which maximizes

shareholders' wealth.

Equity

The difference between the market value of equity and the book value is that the market

value of equity considers growth potential. As the company’s stock price and outstanding shares

change in value, so does its market value of equity (Ross et al., 2013). The calculation used to

determine the market value equity is stock price multiplied by the number of outstanding shares.

The stock price for Apple as of December 31, 2014 was $112.82, and the shares outstanding

were 5,826 (see Table 3). Consequently, the market value of equity for Apple is $657,289

million. Additionally, the expected rate of return for Apple is 6.59% and is equal to the equity

cost of capital (Ross et al., 2013). The expected rate of return for Apple is determined by using

the CAPM formula (see Equation 5).

Debt

Evaluating the cost of debt allows investors to understand the riskiness of the company.

A company with a high debt presents greater risk of doing business. A company can obtain debts

through loans, bonds, and many other forms. The long-term debt value for Apple as of

September 27, 2014 was $28,987 million, with a tax rate of 26.1% (Apple Inc., 2015a). The

company had an interest expense of $384 million (Apple Inc., 2015a). Taking Apple’s $6,310

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million current portion of debt into consideration, the company has a total debt of $35,297

million, and a borrowing rate of 1.08% (=$384 / $35,297). Consequently, the after tax cost of

debt for the company is .80%, determined by using the formula:

After tax cost of debt=(1−Tax rate ) × Borrowing rate ( 8 )

Weighted Cost of Capital

A company’s assets are financed by equity and debt. Taking into account Apple’s CAPM

of 6.59%, the cost of equity is also 6.59% as determined by the CAPM formula (see Equation 5).

The WACC is the company’s average pay to its security holders that is necessary to finance

assets. Apple’s market value of equity is $657,289 million, and the company’s total debt is

$35,297 million. Consequently, the weight of equity is 94.9%, as determined by the formula:

Weight of Equity= Market Value of EquityMarket Valueof Equity+Total Debt

( 9 )

The weight of debt for the company is 5.10%, and is determined by using the formula:

Weight of Debt= Total DebtMarket Value of Equity+Total Debt

( 10 )

Based on the equity and debt value, the total market value of Apple’s WACC is $692,586

million. To find the weighted average cost of capital for Apple, the formula used is:

RWACC=s

b+s× Rs+

bb+s

× Rb × (1−t c ) ( 11 )

Utilizing Apple’s equity and debt market values, in addition to the company’s tax rate

and stock return value, Apple’s weighted average cost of capital is 5.86 (see Appendix A). Based

on the results of the WACC, Apple pays 5.86% on every dollar that it finances. In addition, the

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company has a return on investment capital of 27.14% (see Equation 7). Considering Apple

generates a higher return on investment than the cost of raising capital, it has excess returns.

Consequently, the company has a positive excess of returns and will likely see its value increase

in the future.

Capital Budgeting Assumptions

Equity can also be measured in market value rather than book value (Ross et al., 2013).

Profitable projects raise both book value and market value of equity. Projects funded with debt

raise the debt level. At some point, however, the debt may become exhausted if the company

does not generate a high return on investments. Investors use various methods to determine the

effects of a project’s financial value. Capital budgeting involves making assumptions about a

project’s future. Based on the results of a capital budget, investors can make their decision on

whether they should invest based on the risk. However, assumptions may lead to inaccurate

information and unexpected results. WACC helps determine whether a project is feasible and

worth the financial risk (Ross et al., 2013). The assumption is that a high WACC will continue to

produce positive results at a constant rate. Consequently, the project risk will remain low.

Competitive Review of Debt and Equity Mix

Microsoft is a registered publicly traded company that competes within similar markets

as Apple (Apple Inc., 2015a; Microsoft Corporation, 2014). Microsoft and Apple offer products

including operating systems for computing devices, portable media players, mobile phones and

tablets, software, management tools, and personal computers. Additionally, both companies

distribute their products worldwide through online media, direct sales force, retail stores, through

third-party wholesalers, and cellular network carriers. Similar to Apple, Microsoft sells its

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products and services directly to consumers, small and mid-sized businesses, educational

institutions, enterprises, and government agencies (Microsoft Corporation, 2014).

Competitive Review

Microsoft had a beta coefficient of 0.88 as of December 31, 2014 (Reuters, n.d.); which

indicates a lower risk factor if held within a well-diversified portfolio (Ross et al., 2013). The

expected market return value is .0722, calculated by adding the United States Treasury 52 week

bill of .0022 and the average historical equity premium of .07. The CAPM is .0610, as

determined by calculating .0022 + .88 x (.0700 - .0022). The expected rate of return for

Microsoft is 6.10%. The estimated growth rate in earnings for the company is 14.70%. Given a

$1.07 total dividend paid per share for 2014, and a $47.02 price per share as of December 31,

2014; the discount rate for Microsoft is 16.97%. The stock price for Microsoft as of December

31, 2014 was $47.02, with shares outstanding of 8,299. Consequently, the market value of equity

for Microsoft is $390,219 million.

The long-term debt value for Microsoft as of June 30, 2014 was $20,654 million, with a

tax rate of 21%. The company had an interest expense of $597 million. Considering Microsoft

had zero current portion of debt, the company’s total debt is $20,654 million, with a borrowing

rate of 2.90% (=$597 / $20,654). The total after tax cost of debt for the company is 2.29% (see

Equation 8). Microsoft’s market value of equity is $390,219 million, and the company’s total

debt is $20,654 million. Consequently, the weight of equity is 94.98% (see Equation 9). The

weight of debt for the company is 5.02% (see Equation 10). Considering Microsoft’s equity and

debt market values, in addition to the company’s tax rate and stock return value, Microsoft’s

weighted average cost of capital is 5.9% (see Appendix B).

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Table 5

Microsoft and Apple Debt and Equity Information (in millions, except for capm, debt borrowing

rate, tax rate, and wacc)

Apple Value

Market value of equity $ 657,289

Market value of debt $ 35,297

CAPM 6.59%

Debt borrowing rate 1.08%

Tax rate 26.1%

WACC 5.86%

Microsoft Value

Market value of equity $ 390,219

Market value of debt $ 20,645

CAPM 6.10%

Debt borrowing rate 2.90%

Tax rate 21%

WACC 5.9%

Apple has a higher market value of equity and debt than Microsoft (see Table 5). In

addition, Apple’s WACC is higher than Microsoft, which signifies that Apple has a higher

financial risk and capital structure (Ross et al., 2013). Consequently, Microsoft requires a lower

rate of return on projects with raised capital. Considering the overall company value, Apple has

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$267,070 million more in equity than Microsoft, and $14,652 million more in debt, making

Apple’s debt-to-equity ratio greater than Microsoft’s.

Capital Structure Theories

Capital structure is the financial framework used by organizations, which includes the

equity and debt mix. Using a combination of debt and equity, capital structure helps

organizations select the most optimal form of financing to maximize market value and minimize

the cost of capital. Companies have the ability to lower weighted average cost of capital if they

have financial leverage (Agca & Mozumdar, 2004). Financial leverage is regarded to as a firm's

fixed cost of finance (Ross et al., 2013). The company's WACC decreases with financial

leverage until the optimal debt ratio is achieved. Once the ratio is achieved, the WACC rises with

additional debt (Ross et al., 2013). Financial interest is tax deductible, which increases debt

capital structure and is beneficial for tax benefits. Considering trade-off theory assumes company

bankruptcy risk, the market capital is increased as the WACC decreases (Agca & Mozumdar,

2004).

According to the trade-off theory, firms turn to debt to relieve financial needs.

Additionally, large companies may rely on less debt unless they have a large amount of cash

flow. Within the trade-off theory, accumulated debt is used to capture tax shields and leverage

firm benefits (Ross et al., 2013). In addition, the theory works best within company's that have

high growth potential. Trade-off theory helps organizations determine the most optimal debt-to-

equity ratio by balancing the cost and benefits. In addition, the theory states that there are

advantages to financing projects with company debt.

Pecking-order theory is aimed at companies with a large borrowing capacity and states

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that firms finance their projects through internal funds. In situations where there are no internal

funds, organizations may issue debt, and then equity as a last resort (Faulkender, Milbourn, &

Thakor, 2006). Smaller firms often borrow at a smaller rate based on needs rather than optimal

capital structure. Consequently, pecking-order theory can easily be applied to these types of

firms. However, the theory fails smaller firms because smaller firms are less likely to have an

abundance of cash on hand and debt is often the best option. Pecking-order theory states that the

financial decisions within a firm are affected by the managements attempt to minimize

shareholder supervision (Faulkender, Milbourn, & Thakor, 2006). Furthermore, the theory states

that bonds are a lesser risk for stock declines. Considering it is likely that firms will need cash

within the future for projects, the theory suggest cash should accumulate so that capital markets

are not fully needed in the future (Ross et al., 2013).

Selecting the optimal capital structure is crucial in uncertain business environments. To

determine the proper capital structure, a company should have a comprehensive understanding of

its financial position. Selecting the right capital structure is situational and dependent upon the

needs of the company. For optimal results, management must weigh all long-term options before

selecting either trade-off theory or pecking-order theory.

In 2014 Apple had a long-term debt of $28,987 million, with a net income of $39,510

million. Consequently, the company has the annual funds necessary to fully pay its short-term

and long-term debt obligations. The ratio of debt at the company is optimal for maximizing

market capitalization and debt levels. Apple and Microsoft both exemplify the use of capital

structure theory and have a relatively low debt level compared to equity (see Table 5).

Considering both companies have high cash holdings, and the primary source of financing new

projects come from retained earnings, this supports the pecking-order theory.

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Summary

The profit margins for Apple over the past three years have been relatively steady

between 21.67% in 2012 and 2013, to a current 21.61%, which represents a small decline over

the past year. The company has a net income of $39.51 billion (see Table 3). The company’s

retention ratio is .72 (see Table 4), and the ROE is 35.42% (see Table 4). In 2014, Apple's

earnings growth rate was 25.45% (see Table 4). Consequently, the company has a feasibly

expected growth rate for the future. Apple's quarterly dividends have been constant at $0.47 for

the year of 2014 (see Table 3), which reflects the growth rate of the organization's stock. Price to

earnings ratio for Apple is 19.37%, which is lower than the company’s growth rate. A lower

price-to-earning ratio signifies less growth opportunities (Ross et al., 2013).

Apple has a beta coefficient of 0.94, which is less than the market average of 1.0, making

the company less volatile and less risky than the general market. The CAPM for Apple is .0659.

Consequently, the expected rate of return is 6.59%, which is lower than the average historical

equity premium of 7% (Ross et al., 2013). Based on the equity and debt value, the total market

value of Apple’s WACC is $692,586 million, with a weighted average cost of capital of 5.86%.

Apple generates a higher return on investment than the cost of raising capital, which signifies

that the company has excess returns and will likely see a value increase in the future. As of April

13, 2015, the current value of Apple’s stock is $126.85, which is an increase of $14.03 from its

December 31, 3014 value of $112.82. Within a highly competitive and evolving industry, the

company’s valuation is dependent on the company’s ability to continually develop and innovate

new products and services. As the leader within its industry and as a dividend paying company

with a high stock value that continues to increase; based on the company's financial data, Apple’s

stock is recommend as an investment.

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Reference

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Apple Inc. (2015a). Apple Inc. 2015 annual meeting of shareholders. Retrieved from

http://investor.apple.com

Apple Inc. (2015b). Apple Inc. investor relations - dividend history. Retrieved from

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Appendix A

Weighted average cost calculations for Apple.

The formula used to determine the weighted average is:

RWACC=s

b+s× Rs+

bb+s

× Rb × (1−t c )

S is the equity market value (in millions) = $657,289

B is market value of debt (in millions) = $35,297

Rs is the stock return (CAPM) = 6.59%

Rb is the debt borrowing rate = 1.08%

tc is the average tax rate = prov. of income tax / before tax = $13,973 / $53,483 = 26.1%

RWACC=$ 657,289

$ 35,297+$657,289×6.59 %+ $35,297

$35,297+$ 657,289× 1.08 %× (1−26.1 %)

= $657,289/692,586 x .0659 + $35,297/692,586 x .0108 x (1 - .261)

= .949 x .0659 + .0510 x .0108 x .739

= 5.86%

26

Appendix B

Weighted average cost calculations for Microsoft.

The formula used to determine the weighted average is:

RWACC=s

b+s× Rs+

bb+s

× Rb × (1−t c )

S is the equity market value (in millions) = $390,219

B is market value of debt (in millions) = $20,645

Rs is the stock return (CAPM) = 6.10%

Rb is the debt borrowing rate = 2.90%

tc is the average tax rate = prov. of income tax / before tax = $5,746 / $27,820 = 21%

RWACC=$ 390,219

$20,645+$ 390,219× 6.10 %+ $ 20,645

$ 20,645+$ 390,219×2.90 % × (1−21 %)

= $390,219/410,864 x .061 + $20,645/410,864 x .029 x (1 - .21)

= .949 x .061 + .0502 x .029 x .79

= 5.9%