Capital structure is defined as the mix of debt and equity or any other long-term sources of funds used to finance a firms investment and operating activities. The capital structure of a given firm reflects its financing decisions; for example, the design and timing of a particular debt issue. Various studies of capital structure debate the impact of capital structure on a firm′s value. In the first part of a paper, Modigliani and Miller's Capital Structure Theory is discussed more closely, including the assumptions and its criticisms. Business and financial risks related to capital structure of an Apple Inc. are identified, as a basis for understanding the optimal capital structure being applied. The second part contains analysis and estimation of Apple′s optimal capital structure and important findings regarding the research.
Preview of the capital structure issues
Perhaps the earliest cross-sectional observations about capital structure came from industry studies, which documented significant differences in leverage across sectors. Regulated utilities and real estate firms, for example, tend to use substantial amounts of debt financing while firms in more technology-oriented industries tend to use very little debt. Thus, the capital structure of companies tend to variate within different industries. For example, as of early 2008, the debt-to-equity ratio of ConocoPhillips was over three times larger than that of ExxonMobil, despite the fact that they are very similar integrated oil companies. In order to explain these cross-sectional and time-series differences, capital structure theory focuses on the costs and benefits of the use of debt vs equity financing. When compared with equity financing, three aspects of debt financing deserve special consideration. First, the interest payments on debt are tax-deductible, whereas dividends paid to shareholders or not. Second, debt is a hard claim that generally forces the firm to make cash disbursements regardless of its economic condition. Third, debt has strong liquidation rights which can affect the decisions of firms when liquidation is likely.
Business and Financial Risk Related To Capital Structure of Apple Inc
In 2011 the Apple′s Inc. retail stores have required substantial fixed investment in equipment and leasehold improvements, information systems, and personnel. The company also has entered into substantial operating lease commitments for retail space. Due to the high fixed cost structure associated with the retail segment, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease termination costs, write-offs of equipment and severance costs. The Apple Inc. has many invests, and with new opportunities it may also invest in the future into new business strategies and products development. Sometimes such activity can brings high risks and the potential of unexpected expenses. The Apple Inc. derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S. and foreign laws and regulations increases the costs of doing business in foreign jurisdictions.
Modigliani and Miller's [MM] Capital Structure Theory
In 1958, Modiglani and Miller published their research stating that the value of a firm does not change with the change in the firm′s capital structure. The behavioural model developed by Modiglani and Miller theory is one of the leading theories that support the net operating income approach. It states that capital structure is irrelevant. The basic concept of Modiglani and Miller hypothesis is that the value of the firm is independent of its capital structure and determined solely by its investment decisions. Thus, the left-hand side of the balance sheet that contains the company′s investments is important for assessing its market value and no heed should be paid to the righ-hand side of the balnce sheet with liabilities side that shows the financing deicsions of the firm.
Criticisms of the MM model and Assumptions
Assumptions of the MM model
− There are perfect capital markets with perfect information available to all investors and no transactionm costs.
− The investors are rational. They evaluate risk and return of each investment proposal rationally before investing.
− The firms can be classified into distinct homogenous risk classes.
− There is a zero-tax environment.
− Only debt and equity are issued in caase the firm needs funds and debt is riskless.
− There are no costs of financial distress and liquidation.
There are few reasons which argue against the MM model. They are :
− Leveraged firms have high risk of bankruptcy. Under high debt leveraging, the firms become unattractive due to high-risk component.
− Unlike MM model, the real world markets are not perfect.
− In real world, there exists a tax environment.
− MM model talks about risk class of different firms but does not discuss the implications of the risk of firms due to leverage, on the firm′s value.
Capital Structure Evidence and Implications to Apple Inc
MM theory suggests that the value of the firm with financial leverage is equal to the value of the firm without financial leverage, plus the present value of the debt tax shield. It is true that increasing the use of debt finance increases the risk to equity holders and the cost of equity rises. However, the increase in cost of equity is not large enough to entirely offset the benefit from adding cheaper debt finance. In a world with income taxes and tax-deductible interest expense, an increase in the use of debt finance increases firm value and decreases the firm′s overall cost of capital. If this were the only real-world condition that impacted firm value and cost of capital, the firm′s optimal capital structure would be heavily weighted toward debt finance. In reality, companies try to have little or no debt, and the long-term debt is often rather lower than equity. For example, such companies as Apple Inc. and Microsoft have a 0% long term debt as a percentage to total capital, and their competitor Dell only 10.85%.
Estimating Apple Inc's Optimal Capital Structure
For purposes of capital structure analysis The WACC average was calculated. The cost of equity was found using the Capital Asset Pricing Model, or CAMP. In calculations was used a risk-free rate of 3.95%, which is the three year average of the yield on 30-year treasury bonds. The preference for 30-year treasury bonds was given due the long term horizon of equity investment. The only three years were averaged cause of the relatively volatile nature of the technology industry. The market risk premium value was chosen as 4.77%. Totally, after all calculations the cost of equity resulted in 9.03%. Cause Apple has no debt outstanding, the cost of capital was chosen as an average on comparable technology companies with high debt ratings. The pre-tax cost of debt applied was 4.6%. As Apple has no debt on its public balance sheet, the cost of debt was applied to the present value of operating lease payments. The cost of debt comprised only 1.5% of the total capital structure. This means, as most of the technology firms Apple Inc.′s capital strcuture is based almost on equity. Thus, the cost of equity had the greatest effect on the WACC with a 98.5% portion. The calculated WACC is to be 8.94%, which is almost equal to cost of equity.
Research Method
During the research, the Apple Inc.′s financial statement and balance sheet was carefully analysed. Mostly, in order to identify its optimal capital structure and the common patterns similar to the technological companies competitors of Apple Inc. It was decided to calculate the WACC , cause it is a useful instrument to estimate company′s cost of capital. All companies calculate their own cost of capital as a part of the investment analysis process. For calculating the cost of equity percentage the Capital Asset Pricing Model was applied. According to model such components were included: (1) the risk-free rate,(2) the market risk premium, (3) and the beta coefficient. In order to identify the cost of debt balance sheets of most high debt rating technological companies were analysed too.
Results and Findings
The cost of capital for Apple Inc., based on the WACC, is 8.94%. This means, on average, it costs Apple 8.94% to raise a dollar of long-term capital from external investors to fund investment projects. If an investment project is expected to earn a rate of return in excess of the firm′s cost of capital, it should be accepted. Otherwise, the investment project should be rejected. This is why a firm′s cost of capital is often called the hurdle rate. The main idea is that firm with a lower cost of capital or hurdle rate will be able to accept more projects than a firm with a higher cost of capital. This tendency is clearly seen in the Apple′s capital structure as the cost of equity portion is 98.5% of the total.
Conclusion
Research shows that technological companies like Apple Inc. with large investment opportunities, working in fast-growing and expanding industries usually try to minimize the level of debt in their capital structure. Mostly because the debt finance creates debt service, and large amounts of debt and debt service can be dangerous for a fast-growing company. Such capital structure also provides company with an opportunity to accept many investment projects. This happens mostly because management of the company fears that usage of debt may leave no chance for a new investment. Simply because the free equity will be translated to cover the debt and they will have no money to implement some perspective projects. This thing is very important in the world of fast-growing technological companies, and Apple is one of the best among others. The reputation of a company and brand name must be also on high level and debt burden may bring negative effects for those one.
