Assumptions of capital structure theories

Running head: CAPITAL STRUCTURE OF APPLE INC. 1

CAPITAL STRUCTURE OF APPLE INC. 11

Capital structure of Apple Inc.

Capital structure of Apple Inc.
Abstract
This paper sought to determine how the capital structure of Apple Inc. is affected by concepts learned in chapter 15. To find out the truth, I reviewed multiple literatures, as well as Apple’s financial reports and tested for the similarity and dissimilarities. I first reviewed the capital structure issues faced by Apple Inc. and discovered that Apple uses non-financial liabilities to measure its leverage, yet it is not supposed to be so (Welch, 2010). Secondly, I found that Apple Inc. usually regard the issuing out of equity as equal to changing its capital structure, yet the two have weak correlation (Welch, 2010). I also looked at business and financial risks related to capital-structure of Apple Inc. and discovered that companies usually incur high financial risks whenever they try to reduce their business risks (relying more on debts than equity).

I then looked Modigliani and Miller’s [MM] capital-structure theory where I discovered that the theory disputes the idea of relying on leverage levels to determine the value of the company. Instead, it postulates that the valuation of the company should depend on its future growth prospect and its profitability. That is, the valuation of the company is highly correlated to its operating profits and growth prospects. Next, I delved into various weaknesses associated with MM theory and I found that the theory’s assumption that there is no taxation is untrue since in real-world firms are prone to taxation.

After that, I looked at the Capital-structure evidence and implications and found that some elements in Apple Inc. support, whereas, others disapprove MM model’s rationale. For instance, valuation of Apple Inc. is highly depended on operating profits and growth prospects, which implies that the Modigliani and Miller’s [MM] capital-structure theory is true. However, Apple Inc. is prone to taxes, a reality which contradicts Modigliani and Miller’s [MM] capital-structure assumption that there are no taxes.

I finally looked at Apple’s rationale of estimating its optimal capital structure. I discovered that whenever business risk is high, Apple Inc. usually relies more on debts for financing than on stoke. I also noted that Apple’s management is conservative and they usually rely more on equity than debts, whenever the future growth prospect and profitability is high. In conclusion, Apple Inc. obeys some of the Modigliani and Miller’s [MM] capital-structure theory, and at the same time, it disapproves others.

Table of Contents

2 Capital structure of Apple Inc.

2 Abstract

4 A Preview of Capital Structure Issues of Apple Inc.

5 Business and financial risks related to capital-structure

5 Modigliani and Miller’s [MM] capital-structure theory

6 Criticisms Of The MM Model And Assumptions

7 Capital-Structure Evidence and Implications

7 Estimating The Firm’s Optimal Capital-Structure

7 Business risk

8 Tax position

8 The need for financial flexibility

8 Managerial conservativeness

8 Growth opportunities

9 Annotated bibliography

A Preview of Capital Structure Issues of Apple Inc.
This paper highlights common problems in the capital structure of Apple. One, although it not yet clear whether or not they should be regarded as a debt, non-financial liabilities should not be regarded as equity, yet that is what Apple Company does. Apple uses financial-debt-to-asset ratio to measure their leverage thus committing the above-highlighted mistake (Welch, 2010). So apple should avoid using financial-debt-to-asset ratio in future so as to avoid this capital structure issue.

Two, the activity of issuing out equity should never be considered as equal to capital structure changes, yet that is what Apple management does. In reality, there is a weak correlation between the literature of capital issuing and capital structure, and so it is wrong to regard the two as equivalent to each other (Welch, 2010).

Business and financial risks related to capital-structure
The process of determining a company’s optimal capital structure requires firm’s managers to make critical decisions which involve a trade-off between profitability and risk. Financial risks refer to change in company’s cash flow as a result of overreliance on debt for finances. The risk arises because the debt may become too expensive for company bear, as a result, much of shareholders’ portion will be used to cater for the debts (Graham, 2015). Business risk, on the other hand, is the riskiness which faces the company as a result of not using debts to finance its operations. The rationale here is that interests on debts are taxable thus reducing the cost of firm raising money (Manawaduge, 2010).

Apple finances its operations using both debt and equity. In last financial year, Apple financed most of its operation using equity, thus having a lower leverage. As a result, the company realized incredibly high profits than when it relied heavily on debt for finances (low leverage). Simply put, Apple’s leverage is negatively related to its profitability (financial risk). High leverages usually create agency issues among Apple’s stakeholders and financial creditors who respond by withdrawing their investments. So apple’s management usually pays a lot of attention while financing its operations (avoid over-reliance on debts) in order to avoid upsetting the company’s creditors and shareholders.

Modigliani and Miller’s [MM] capital-structure theory
This theory states that valuation of a company is not affected by its capital structure (i.e., the level of leverage does not affect its market value). Instead, the firm’s value is determined by the level of its operating profits. Modigliani and Miller Approach also argue that the market value of a firm is not only affected by the risk associated with the investment but also its future growth prospect. So the firms with high future growth prospects usually have high market values; consequently, their stock attracts high prices.

This theory assumes that. One, the market is tax-free. Two, purchasing and selling security bear no transaction costs. Three, there is asymmetric flow of information among the investors. Four, both investors and firms incur the same borrowing costs. Finally, financing debts don’t affect the company’s EBIT.

Simply put, Modigliani and Miller’s [MM] capital-structure theory suggests that investing in leveraged and non-leveraged firm bears the same cost as long as then the two have equal future growth prospects and operating profits. In Apple Company, the valuation of the company is based future growth prospects and profitability, and not its leverage.

Criticisms Of The MM Model And Assumptions
MM model and assumptions have various flaws, as result, they are prone to a lot of criticism. One, the model assumes that there is no tax, yet in the real world there is a tax levied on firms. Two, the MM model assumes financing debts does not affect the company’s EBIT, yet, in reality, they do. In Apple Inc., a change in its debts usually have a significant influence on the firm’s EBIT. Finally, the MM model’s assumption that investing in leveraged and non-leveraged firms bear equal costs so long as they have similar prospects and profits is untrue. This is because, in leveraged firms, some of the profits are used to repay the debts’ interests, consequently, the cost is high.

Capital-Structure Evidence and Implications
Based on the balance sheet of Apple Inc., there is a significant relationship between its financial performance and its capital structure, such that high leverage resulted in low profitability. The results are inconsistent with Modigliani and Miller's theorem. Apple also incurs taxes which again violates the rationale of Modigliani and Miller's theorem. However, the valuation of Apple Inc. is depended on its future growth prospect and operating profits. This evidence is in line with Modigliani and Miller's theorem.

Estimating The Firm’s Optimal Capital-Structure
The optimal capital structure of a company refers to the mix of equity and debt that maximizes the process of the shares. Managers of any company usually have a particular target capital structure (optimal capital-structure) which changes as time goes by. For instance, a firm may select a 60 percent equity financing and 40 percent debt financing of its operations.

However, before determining the firm’s optimal capital structure, the managers must consider factors below.

Business risk
Business risk is the riskiness which faces the company as a result of not using debts to finance its operations. If the business risk is high the firm’s capital structure will rely more on debts for financing than on stoke. Apple Inc. usually employs this trend.

Tax position
Debts are usually prone to taxation thus reducing the cost of raising funds in the firm. So the higher the tax position the more the firms will prefer to fund their operations using debts than stoke. The similar trend is observed in Apple.Inc.

The need for financial flexibility
The firms that are highly in need of financial flexibility will always set their optimal capital-structure at almost 50-50, such that 50 percent of their funds will be from debts and the other 50 percent, stoke. Apple usually follows this trend but it depends more on equity than debts for funding.

Managerial conservativeness
Conservative management is the one which is highly profit-oriented. Such management relies heavily on stoke for funds than debts. Apple’s management is profit oriented but does not over-rely on stoke.

Growth opportunities
A firm that has high growth opportunities will highly rely on stoke for funding since they will be anticipating an increase in their stoke prices (Indrani, 2015). Apple Inc. usually follows this trend.

Annotated bibliography
Welch, I. (2010). Common problems in capital structure research: The financial-debt-to-asset ratio, and issuing activity vs. leverage changes.

This paper highlights two common issues in the capital structure that are experienced in various firms. The first one is that non-financial liabilities should not be regarded as equity. Two, equity issuing processes should not be considered as a change in capital structure of a company. This source is highly useful in my research as it points out acts that Apple Inc. should not do, yet it does. For instance, Apple uses financial-debt-to-asset ratio to measure its leverage which is a mistake. Secondly, Apple’s management usually views equity issuing processes as changes in its capital structure.

Indrani Chakraborty (2015). The Effect of Business Risk on Capital Structure of Indian Corporate Firms: Business Groups vs. Stand-alone Firms, Global Economic Review, 44:2, 237-268.

This paper estimates the relationship that exists between business risk and leverage for Indian corporate firms. It found that the higher the leverage the lower the business risks in Indian firms. This paper is highly relevant to my research as it explains the effect of reliably heavily on debts for funding (high leverage) on business risks. This means that Apple Inc. should rely a lot on debts if it wants to reduce its business risks, as debts’ interests are prone to taxation, consequently, the costs of accumulating funds will reduce significantly.

Manawaduge, A. S., De Zoysa, A., & Chandrakumara, P. M. K. (2010). Capital structure and its implications: empirical evidence from an emerging market in South Asia.

This paper examined the influence of capital structure on the performance of 171 firms in Sri Lanka. The paper found that most firms funded their operations with short-term debts over long-term debts. This paper also highlighted the fact that over-reliance on debts for funding had negative effects on the firms. This is highly relevant to my research as it shows that Apple Inc. should not rely heavily on debts for funding as it will result in financial issues (low profitability).

Graham, J. R., Leary, M. T., & Roberts, M. R. (2015). A century of capital structure: The leveraging of y

This paper postulates that most of the American firms increased their leverages between the year 1945 and 1970, from 11 percent to 35 percent. This was a great increase but still, most of the firms continued to stabilize their operations and made huge profits. This source is highly useful to my research as it proves that relying on debts is not a bad Idea, and so it can as well enable Apple Inc. to make profits. This supports the idea that relying on debts for funding reduces debt risks.