As an investment banker you have been asked to advise on whether Apple should in
ID: 2716316 • Letter: A
Question
As an investment banker you have been asked to advise on whether Apple should introduce debt into its capital structure. Apple currently has zero debt outstanding, i.e. it is currently an all-equity firm. Apple has 938,649,000 shares outstanding. Apple pays dividends quarterly. Its last dividend (which it has just paid) was $2.65 and dividends are expected to grow by 1.60% per quarter for the next fifteen years and 1.00% per quarter thereafter forever.
Apple is considering issuing 17 million ten-year 3.2% coupon bonds. The bonds each have a face value of $1000 and the coupons are paid semi-annually.
You may assume that the equity beta for Apple is 0.86; that Apple can borrow at the risk-free rate; a market risk premium of 5%, a risk-free rate of 3% (annually compounded); and a tax rate of 35%.
i. Using CAPM, what is cost of equity for Apple?
ii. Using the DGM, what is the share price for Apple?
iii. What is the total value of equity in $millions (the market capitalization) for Apple?
iv. What is the market value of the debt in $millions that Apple is considering issuing?
v. The median debt-to-value leverage ratio for Apple’s competitors is 10%. How does Apple’s leverage ratio compare with this? Describe one advantage and one disadvantage of having higher leverage. Based on your answers, do you advise that Apple raise more or less debt than the proposed 17 million bonds? Why?
Explanation / Answer
(i)
CAPM cost of equity = Risk free rate + Beta x (Market premium)
= 3% + 0.86 x 5% = 3% + 4.3% = 7.3%
(ii)
1.6% growth per quarter = 6.4% growth per year
Dividend price after 15 years = $2.65 x (1.016)60 = $6.87
Stock price at end of year 15 = $6.87 x 1.01 / (0.073 - 0.01) = $110.14
Its present value = $110.14 / (1.073)15 = $38.28
Present value of dividends in first 15 years = $2.65 x Present value interest factor of annuity, PVIFA(7.3%, 15 years)
= $2.65 x 8.9378 [From PVIFA table]
= $23.69
Current stock price = Present value of all future cash inflows = $(38.28 + 23.69) = $61.97
(iii)
M-Cap = Number of shares x Current share price
= 938,649,000 x $61.97 = $58,168.08 million
(iv)
Market value of debt = 17 million x $1,000 = $17,000 million
NOTE: Out of 5, the first 4 sub-parts are answered.
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