## Summary

- Untapped value can be "manufactured" by Apple at will by simply taking on more debt and with little risk of impacting the company's ability to innovate.
- We estimate that under an "optimal capital structure" the expected value per share is $847.
- With significant cash reserves and massive debt capacity, it's a wonder that Tim Cook has not pursued a leveraged management buyout already.

We compared the value of Apple Inc. (NASDAQ:AAPL) under the company's "current target" capital structure (estimated by the 3-year rolling average debt to enterprise value) versus an estimated "optimal target" capital structure to determine whether additional leverage would create significant value for shareholders. Needless to say, the difference is significant and this is precisely why Carl Icahn has been aggressively lobbying Apple to take on more debt. It was through this process that we realized that the debt capacity for Apple and the significant cash reserves could make a leveraged management buyout, in partnership with a syndicate of financial sponsors, possible.

Although more debt can add greater risk and hence increase the cost of equity and debt, it can also be a cost effective source of capital when managed responsibly. The reason is that the interest expense can be deducted from income, acting as a tax shield. The trick is to determine the optimal level of debt such that the benefit of the tax shield offsets the increased risk of default. As more debt is taken, the risk of default increases and hence the cost of equity and debt will also increase. So what is the optimal amount of debt?

(Figure 1) We approximate that the company's optimal capital structure to be 52% debt to enterprise value, or where the weighted average cost of capital is at its minimum.

Figure 1: Optimal Capital Structure

For illustrative purposes a quick calculation can give us an estimated value of the interest tax shield (ITS). Given the market value of the company is approximately $568 billion (as of May 29th, 2014), the debt would be approximately $295 billion (52% x $568 billion). Roughly speaking, this amount of debt would generate an interest expense of $20 billion (assuming a pre-tax cost of debt of 6.9% x $295 billion) and interest coverage ratio of around 2.48x ($50 billion LTM EBIT ÷ $20 billion), resulting in an estimated credit rating of around BBB-. The ITS would be $8 billion ($20 billion interest expense x 40% marginal tax rate). We assume the ITS to grow at the same rate as the unlevered Free Cash Flow to the Firm (FCFF) at 4.7% with an unlevered cost of equity of 10.8%. Consequently, the value of the ITS equates to approximately $132 billion ($8 billion / [10.8% - 4.7%]) or an increase in share value of $154 ($132 billion ÷ 861 million shares). This rough estimate provides a first step in conceptually understanding how much increased leverage will impact shareholder value.

## A Multi-Period Analysis

Taking the analysis further, instead of using the most recent single period performance as an estimate of future performance, we forecast multi-period estimates of operating performance using the same assumptions under both the current and optimal target capital structures (Table 1).

Table 1: Operating Driver Assumptions

From the driver assumptions above, we can derive values for our input assumptions (Table 2), which remain the same under both capital structure scenarios.

Table 2: Values for Operating Drivers

To explicitly derive the value of the interest tax shield associated with debt, we use an Adjusted Present Value (APV) calculation (Table 3), which mathematically equates to a Discounted Economic Value (DEV) and Discounted Cash Flow (DCF) model.

Table 3: APV Assumptions and Calculation - Current Target Capital Structure

(Table 4) We make the same calculation with the optimal target capital structure using a lower weighted average cost of capital.

Table 4: APV Assumptions and Calculation - Optimal Target Capital Structure

Table 5 shows that under the current target capital structure the company is already undervalued by 11.7% with a share value of $709. By simply taking on more debt, Apple can create $194 billion of value for shareholders, which would increase the share value to $935.

Table 5: Current versus Optimal Target Capital Structure

## Valuation Assumptions under Uncertainty

Although a multi-period calculation provides a better understanding of how leverage impacts value, it relies too heavily on one set of projections. We find that when dealing with decisions of uncertainty, assumption ranges are more realistic than precise point estimates. It also helps to quantify the level of uncertainty of our estimates.

As a result, we estimated the probability distribution of "fair value" for Apple using a Monte Carlo Simulation for both the current and optimal target capital structure scenarios, while maintaining the same range estimates for Revenue Growth, NOPAT Margin, and Capital Turns. Consequently, NOPAT Margin, Capital Turns and the Cost of Capital can be simplified into one measure that we refer to as Spread.

Spread equals the Return on Capital less the Cost of Capital, where the Return on Capital equals the product of NOPAT Margin multiplied by Capital Turns. This allows us to simply compare the Revenue Growth and Spread of Apple's projections to its historical performance to get a sense of whether our assumptions are reasonable.

Revenue Growth

Beginning with Revenue Growth, the range assumptions of 5 to 10% seem fairly conservative (Table 6).

Table 6: Revenue Growth - Range Assumptions

(Figure 2) Our estimates of Revenue Growth are towards the lower bound of the 90% confidence interval calculated from Apple's trailing twelve month (TTM) quarterly historical performance.

Figure 2: Revenue Growth Benchmarked Against Company's Own Historical Performance

(Figure 3) However, in light of Apple's most recent acquisition of Beats, the anticipated launch of iPhone 6, as well as the rumored entry into the smart home market, we believe these estimates of Revenue Growth to be very reasonable, if not overly cautious.

Figure 3: Revenue Growth -Historical and Projections

Spread

Our estimates of Spread also exhibit a fairly conservative view, when compared to historical performance (Table 7).

Table 7: Spread Range Assumptions - Optimal Capital Structure

(Figure 4) Most recently, Apple's TTM quarterly Spread has declined close to the 75th percentile of its historical performance, but looks as if it is about to rebound or stabilize.

Figure 4: Spread Benchmarked Against Company's Own Historical Performance

(Figure 5) Despite the company's strong historical Spread, we cautiously forecasted that the Spread would decline towards the mean for the next 5 years and then decay towards the 25th percentile of its historical performance.

Figure 5: Historical Spread and Optimal Capital Structure Projections

## Leverage Increases Chance of Upside

Although our range estimates provide a slight margin of safety, Apple is coming closer to its expected share value (Table 8) of $698, given the current capital structure.

Table 8: Monte Carlo Simulation Statistics - Current Target Capital Structure

As a result, the chance of making a 20% return or higher, via a long position, is a low 19% (Table 9).

Table 9: Fair Value Distribution - Current Target Capital Structure

However, the probability of making a 20% return or higher on a long position increases significantly to 82% (Table 10), when the company takes on more debt under the optimal capital structure.

Table 10: Fair Value Distribution - Optimal Target Capital Structure

(Table 11) The additional leverage significantly increases the mean estimate of share value from $698 to $847, providing a greater upside than what we can expect under the current capital structure.

Table 11: Monte Carlo Simulation Statistics - Optimal Target Capital Structure

## Conclusion

Fortunately, Apple seems to have recognized this source of untapped value with the issuance of $17 billion in debt in May of 2013 (Source: Apple Inc. Form 10-Q filed April 24, 2014). Although by most standards, $17 billion is a significant amount of debt, it is not nearly enough for Apple. In fact, our optimal capital structure suggests that with a 52% debt to enterprise value, a controlling interest of the company would not be out of the question.

With such amazing and innovative products, strong executive team and labor force, loyal customer base, significant capacity for debt, $109 billion of cash in marketable securities (Source: Apple Inc. Form 10-Q filed April 24, 2014), it is surprising that Tim Cook has not already initiated a leveraged management buyout of the company. Not to mention becoming a private company might help Apple limit its public exposure and keep the significant levels of cash oversees from becoming a political liability. The good news for shareholders is that the company is still public and there is a significant amount of value that can be created by simply taking on a little more debt.

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