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Rafael Nicolas Fermin Cota

A commentary on the financing mix of Apple



Apple is the greatest corporate cash machine in history and it is fully deserving of its market value. Its history as a disruptive force motivated me in 2013 to write a detailed teaching module, a behemoth weighing in at 150 pages for students to learn how to model the capital structure and cash flow for #Apple.


The intrinsic value of Apple is the present value of its expected free cash flows to the firm, computed after taxes but before debt payments, discounted back at its cost of capital. As Apple borrows more, their free cash flows to the firm should remain unaffected, in most cases, since they are pre-debt cash flows, and a lower cost of capital will translate into a higher value, with one caveat. As they borrow more and the risk of failure/bankruptcy increases, there is the possibility that customers may stop buying their products, suppliers may demand cash and employees may start abandoning ship, creating a death spiral, where operating income and cash flows are affected, in what is termed "indirect bankruptcy costs". In that case, the optimal debt ratio for Apple is the one that maximizes value, not necessarily the one at which the cost of capital is minimized.


If you have taken a corporate finance class, you are probably wondering how the "Right" Financing Mix approach reconciles with the Miller-Modigliani theorem, a key component of most corporate finance classes, which posits that there is no optimal debt ratio, and that the debt mix does not affect the value of a business. That theorem deserves the credit that it gets for setting up the framework that we use to assess debt today, but it also makes two key assumptions, with the first being that there are no taxes and the second being that there is no default. Removing debt's biggest benefit and cost from the equation effectively negates its effect on value. Changing your debt ratio, in the Miller-Modigliani world, will leave the cost of capital unchanged. In the real world, though, where both taxes and default exist, there is a "right" mix (albeit an approximate one) of debt and equity, and companies can borrow too much or too little. And if Apple is already at its right mix of debt choose to add to that debt to fund its dividend payments or buybacks, it is hurting its value by increasing its cost of capital and exposure to default risk. However, since Apple is under levered, i.e., has too little debt, may be able to increase its value by borrowing more to fund its cash return, with the increase coming from the skew in the tax code towards debt.


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