Apple's (AAPL) announcement that it will be returning cash to shareholders by borrowing $17bn has been heavily covered in the media. Journalists have stated that Apple saves $9bn with this maneuver as it can pay the shareholders without bringing its foreign cash back to the US (which will be heavily taxed). However, I think such a statement is very misleading, because Apple still has $102bn of cash in foreign banks, and eventually it needs to be returned. On the other hand, Apple's cash strategy accomplishes two things;
- Over the last 6 months Apple's share price has dropped significantly. But by returning $17bn in cash to shareholders, it could switch the momentum.
- Assuming that Apple can deduct the interest payments at the US corporate tax rates of 35%, the debt will create a tax shield which will benefit shareholders (at the expense of tax authorities).
Some may argue that Apple should avoid all these "complicated" changes to the capital structure and just bring the money home to the US as it doesn't matter if it gets taxed today or 15 years from now on. However, that ignores the possibility that US tax authorities may reduce the corporate tax rate at some point in the future.
In this article I will analyze and quantify how the various strategies Apple could employ with its cash impact the value of the company.
Before I get started with the analysis, it is important to note that I am making some simplified assumptions. For instance I assume that the risk-free rate is 3% (which Apple will receive in interest payments), even though it currently is lower (due to central bank manipulations), however as this is a long-term analysis I think 3% is a decent estimate for average rate over the next 30 years or so.
When/if Apple brings the foreign cash back to the US it will be liable to a US corporate tax rate of 35% minus the 1.2% it already has paid on its foreign income.
I also assume that Apple can deduct interest payments at the US corporate tax rate of 35%, that they will borrow the $17bn at an interest rate of 4%, and that they do not pay taxes on foreign interest rate income.
Strategy 1: Do not bring the cash home until US taxes are reduced
While Apple will be able to obtain a return of 3% y/y return on its foreign cash (until/if it is returned to the US), I believe investors will require a slightly higher premium of 3.25% for two reasons;
- There is uncertainty related to the value of Apple's cash (risk premium).
- Some Apple investors want to invest in a tech-company. Not a company investing in bonds.
Given those assumptions, Apple is "destroying" (0.0025*102) $0.25bn in shareholder value each year. Below I will look at how this assumption impacts the valuation of Apple's cash in two different scenarios.
Scenario 1: US corporate taxes are never reduced.
The cost of the "destructions" can be estimated by using a perpetuity model: 0.25/0.03 = $8.5bn.
By adding the 8.5bn to the after tax value of 102bn we can calculate the total value of Apple's cash: 102*(1-0.35+0.012) -8.5 = $59bn
Scenario 2: US corporate taxes are reduced 10 years from now on, so that Apple pays 25% to the US tax authorities.
After they have been reduced, Apple returns the money to the US, where the cash will be valued at par after taxes have been paid.
Cost of "destructions"; -0.25 *((1.03^-10)/0.03) = $-6.2bn
Total value of cash: -6.2 + 102 *(1-0.25) = $70.3bn
In this scenario the value of Apple's cash is higher as Apple only "destroys" value over 10 years compared to perpetuity in scenario 1, and when it brings the cash home it will only pay 25% to the IRS compared to (35-1.2) 33.8% in scenario 1.
Strategy 2: Apple returns cash to the US as soon as possible
With this strategy, the calculation is easy, as we just need to subtract the taxes that Apple will pay to the IRS from the foreign cash reserves of $102bn.
Value of cash: 102*(1-0.35+0.012) = $67.5bn
Given those 3 calculations, we can see that Apple can increase the shareholder value by bringing the cash home immediately if taxes are never reduced. However, if management believe there is a realistic possibility that they can get some kind of tax relief within the next 10 years, then they will be better off with a more patient strategy.
In the below graph, you can see how the various strategies impact the value of the cash depending on whether and when taxes are reduced.
Strategy 3: Apple borrows $17B and pays them out to investors
This strategy works through the logic that Apple takes advantage of its huge cash reserves by borrowing at a cheap interest rate. Companies which have a solid business model and large cash reserves will receive a better credit rating.
However, even though Apple can borrow relatively cheap, it still needs to pay a slight premium over the risk free rate of 3%. That creates an extra cost for shareholders which needs to be weighed against the value of the tax shield.
Scenario 1: US corporate taxes are never reduced.
Present value of tax shield = (0.04*17*0.35)/0.03 = $7.93bn
Cost of borrowing above the risk free rate ((0.04-0.03)*17)/0.02 = 5.67
Hence the total value of Apple's cash is 59 + (7.93-5.67) = 61.26
In this scenario, the value of the tax shield is higher than the cost of borrowing above the risk free rate. Some may argue that Apple should abuse that fact and leverage its balance sheet further, however that will eventually decrease the credit rating of Apple which will cause the interest rate to go up.
According to my estimations, it should borrow money to pay out to shareholders as long as they can borrow at an interest rate below 4.4% (assuming a long-term risk free rate of 3%). In the below graph you can see a graphical demonstration of this concept.
Scenario 2: US corporate taxes are reduced 10 years from now on to 20%.
Value of tax shield over the next 10 years: (17*0.04*0.35)*(1-1.03^-10)/0.03 = $2.03 B
Cost of debt over risk free rate over the next 10 years: ((0.04-0.03)*17) )*(1-1.03^-10)/0.03 =$1.45bn
Total value of Apple's cash in this scenario is: 70.3 + (2.03-1.45) = $70.9bn
In this scenario Apple's capital structure strategy doesn't increase the fundamental value of Apple significantly. However, an extra $0.6 B in shareholder value doesn't hurt anyone.
Why this matters for investors
As a value investor, whether you prefer to use a DCF model or multiples, the capital structure matters for your valuation. If you use the DCF model you add the present value of the future free cash flow to the value of the net debt (debt - cash). However, taking the book value of the cash at par is a huge mistake, and instead smart investors will analyze how the current and future tax rate impacts the value of the cash.
Given my estimations in this article, I would say that a fair estimate of Apple's cash value is probably around $65bn. So let's say you're an investor who likes to use the P/E-ratio to find undervalued companies. Given the future prospects of Apple you believe that its operational performance should be valued at a P/E-ratio of 10. As Apple's EPS over the last 12 months were 41.89, you believe that Apple (assuming it had a net debt of 0) should trade at a price of 418.9. As Apple currently trades at $457, an investor ignoring the cash balance of Apple would mistakenly come to the conclusion that Apple is slightly overvalued. However by subtracting the value of the cash from the market value of Apple, the "after cash/debt" price of Apple is $388. So that actually means that Apple at a fair P/E-ratio of $418.9 is slightly undervalued.