MGT431 – Group Report

Apple, Einhorn, iPrefs.

Professor Gabor Virag

Group 3

Student Name Student Number

Aman Nadkarni 1004543265

Devika Sholapure 1004595039

Moksh Pachisia 1004506466

Yudi Sun 1005384594

Case Background

Company Information

Apple inc. is an American multinational technology company headquartered in California, that

designs, develops, and sells consumer electronics. According to the 2012 Audit report, Apple has a market

capitalization of $450 billion, a cash balance of $137 billion, and a net income of $42.5 billion. Apple’s

cash levels began growing in 2005 with the sales of iPod. They continued to collect cash with the sale of

the iTunes store, the iPhone, the Apps Store, and the iPad.

Einhorn Proposition

Apple’s shareholders were under the impression that Apple did not return enough cash-back to

them and maintained a high cash balance. David Einhorn, founder and president of the hedge fund

Greenlight Capital was leading the lawsuit against Apple on this issue. He claimed that a form of perpetual

preferred stock, dubbed “iPrefs” would strike a good balance between the company’s strategic needs and

the interests of shareholders.

Apple cash Analysis and Requirements

Apple wanted to keep the cash on their books for the following reasons: It was implied that

“growth” companies would hold onto their cash and do not pay dividends to focus on growth, while

“mature” companies return cash to their investors. If Apple paid high dividends it could send a signal that

Apple was running out of innovative ideas. Keeping cash on their own balance sheet would give Apple the

opportunity to invest in a new, hit product if an innovative idea came up. Having enough amount of cash

on the books allowed Apple to stay debt-free. High interest rates increased the probability of a liquidity

crunch and high cash balance would help Apple avoid that case. 70% of the cash that Apple had was held

overseas, which meant that redistributing it among the shareholders would create a significant tax burden.

Shareholders wanted Apple to redistribute the cash as many investors believed that Apple could

maintain their planned R&D spending, develop new products, and finance attractive acquisitions with much
less cash than was currently on its balance sheet. Shareholders believed even after Apple paid repatriation

taxes; they would be better off with cash in their own pockets

Analysis of Relevant Concepts and Alternatives

M&M Proposition 1 (No Taxes)

VL = VU

VU = Value of the unlevered firm (financing only through equity)

VL = Value of the levered firm (financing through a mix of debt and equity)

The cost of debt is generally less than the cost of equity. The theorem was developed by Franco

Modigliani and Merton Miller in 1958. The theorem states that the value of the firm is independent of the

capital structure of the firm or the financing decisions it undertakes. Desired cash flows can be replicated

by using homemade leverage or homemade dividend by an individual investor and so, the inherent capital

structure of the firm is not important for the targeted amount of cash flows.

The Modigliani Miller theorem assumes perfect markets. The perfectly efficient markets hypothesis

states that asset prices reflect all available information about the actual value of the underlying assets.

Assumptions

- There are no transaction costs in these markets which means no expenses incurred when buying or

selling financial assets. Transaction costs include brokers' commissions and spreads.

- There is no issuance cost of securities which means there are no expenditures associated with

underwriting and issuing debt securities and equity securities.

- There is information symmetry which implies equal access to information by buyers and sellers alike.

- There are no taxes. There is no risk of bankruptcy and no financial distress costs.

- Individuals can borrow at the same rate as the firm

- Firm’s financing actions would not ‘signal’ any new information about its business or its opportunities

- The law of one price is a characteristic of perfect markets which states that identical goods sold in

different locations must sell for the same price when prices are expressed in a common currency.
M & M proposition 2 (No Taxes)

The cost of equity as shown in the figure above is directly correlated with the level of leverage and

it increases with the debt-to-equity ratio. Even as the cost of equity increases with the debt to equity ratio,

the weighted average cost of capital remains the same because with the increase in the debt to equity ratio,

the amount of equity in the firm decreases, refer to Appendix 1 for graphical representation and explanation

of the variables.

M & M Proposition 1 (With taxes)

VL > VU, VL = VU + D x tc

Since debt interest payments are tax deductible, they create additional value for the firm. The first

proposition states that tax shields that result from the tax-deductible interest payments make the value of a

levered company higher than the value of an unlevered company.

M & M Proposition 2 (With taxes)

The presence of a tax shield makes the cost of equity less sensitive to the leverage level. Although

the extra debt still increases the chance of a company’s default, investors react less negatively as it creates

the tax shields that boost its value.

M & M Proposition and the Apple Case (No Taxes)

Einhorn suggests that with financial engineering, he will be able to add $50 bn in equity value to

the firm which is not possible since the value of a company is calculated as the present value of future cash

flows, the capital structure cannot affect it. In fact, the common stock would be devalued by $50 billion to

offset the increase of the share value by issuance of iPrefs. The iPrefs are issued in seniority to common

stock and so if Apple were to go bankrupt, the preferred stockholders would get precedence in payment.

With this piece of information in hand, shareholders will be apprehensive to overvalue the common shares
by $50 billion. Apart from that, the concept of homemade dividends implies that shareholders will be able

to match dividend payouts by adjusting their holdings. We assume that an investor holds 80 shares that are

priced at $450 each that pay a $20 dividend however they prefer to have dividend of $40 and Appendix 2

shows the calculation to create dividends.

Limitations of M&M Propositions

- Markets are rarely perfectly efficient. In most scenarios, there is a lack of information symmetry and

the law of one price does not usually hold.

- The income tax advantages with share repurchases and common stock differ in real market conditions.

Special one-time dividends are taxed lower than common dividends.

- With a change in financing decisions or capital structure, cost of equity or price to earnings multiple

ratios will not stay constant. The 4% yield of the preferred shares is substantially below the current

yield of 6% on a diversified portfolio of preferred stocks indexed by S&P. And so, the issuance of

iPrefs can lower the cost of equity of Apple. There will be a sizeable issuance cost of iPref

- Share repurchases and issuance of dividends may attract value investors as opposed to the issuance of

preferred dividends which attract income investors. Income investors are more interested in

conservative, recurrent, lower return investments and so value investors might end up valuing the

market value of equity more than income investors.

Evaluating Einhorn's Proposal and Implications

David Einhorn, a prominent hedge fund manager, proposed the use of Preference Shares by Apple

to redistribute the cash and reduce the problem of agency costs. These preference shares were termed iPrefs.

Preferred stocks, typically, have no voting rights and have a guaranteed payout per quarter. They are a

hybrid, lying between debt and common stock and they rank below debt but above common stocks when it

comes to payment in bankruptcy.

 Einhorn suggested the issuance of a perpetual, cumulative preferred share with $50 face value,

paying a 4% annual dividend on a quarterly basis, totaling $2.00 annually. iPrefs for each of its 945 Million

shares outstanding would create a balance of $47 Billion on Apple’s books and the company would have

to pay $1.9 Billion per year in iPrefs dividends.

How does this create value to Shareholders?

- Last year’s EPS for Apple was approximately $45. A share price of $450 gave a P/E ratio of 10x

- iPrefs would reduce the income available for common shareholders by $2 to an EPS of $43. A P-E ratio

of 10x would give a share value of $430.

- Add to that $50 in iPrefs and the total value to Apple shareholders increases to $480 per share from the

original $450 per share. We deduct 15% tax on dividends and the share price is $479.70.

Does this solve the problem of agency costs?

Agency costs of equity arise due to conflict of interests between management and shareholders.

When the management diverges from the interests of shareholders, the shareholders must bear the cost.

Agency costs arose due to the conflict of interest between management and shareholders in relation to the

cash held by Apple. Issuance of iPrefs proves to be an innovative way of redistributing cash to shareholders.

However, this would also change the capital structure of Apple adding the preferred shares component to

the Balance Sheet. Capital financial structure does not matter when the markets are “perfect” according to

the M&M proposition. However, the assumption of “perfect” markets is unrealistic. As stated in the case

and by Henry Blodget, a former Wall Street Equity Analyst, one possibility is that a rational market would

reduce the value of Apple stock by $50 Billion. This would reduce the value to shareholders. Moreover,

they would only be getting $2.00 annually as iPrefs dividends – thus, not a great deal of cash being

redistributed. In relation to the tax implications of this proposal, preferred shares do not offer a direct tax

benefit to the company or the shareholders – dividends are paid out of after-tax profits. From the perspective

of preferred shareholders, although the dividends are received similarly to the coupon payments on bonds
in the way that they are fixed payments, they are not taxed as interest, but as qualified dividend. The tax

rate on these dividends is higher than the marginal income tax rate on bond coupons at 15% for the

shareholders which would further reduce value by 30 cents per share.

Demographic Analysis

Prior to 2012, as seen in Appendix 3, the latest dividend paid can be traced back to 1995 at $0.12.

If we check the demographic of investors in 2012, Individual shareholders only accounted for a minor 1%.

Suggesting that only a limited number of investors are willing to hold the full share amount and it is quite

rare for the rest majority to take this audacious move since there’s a quite low chance of dividend payment

at that time. They are somehow deterred by this uncertainty. As a result, we can see that in 2012, most

shares were held by mutual funds, leading by Vanguard. People chose to invest Apple shares through mutual

funds because they can efficiently diversify the risk. Meanwhile, the pooling function in mutual funds

allows investors to own a partial amount of one share. iPrefs are said to provide a perpetual dividend

payment of 4% yield, and the market will reward those shareholders with greater value. According to

Einhorn, “For savers across the country, this product is very much needed.” Since iPref is more secure and

value-adding, investors who are risk averse and take cautious investment prospects will likely take this

iPref in their portfolio. Compared to the common shareholders, this group of investors have preference

toward high liquidity. Therefore, the proportion of individual investors are likely to increase because of the

increased certainty of preferred dividend payment. However, this may reduce interest and demand in Apple

stock which could affect their share price in the long run.

Analysis of Other Alternatives

Payment of One-time Dividends

This alternative evaluates the impact on shareholders’ value when Apple declares a $3 cash

dividend for their shareholders. In terms of feasibility, it would cost Apple more than $2.8 Billion. Based
on their cash reserves, Apple could opt for this alternative without it heavily affecting their short terms

liquidity as they would not have to liquidate their long-term investments. The impact on the share price and

the shareholders’ value differs theoretically and what has been observed empirically due to behavioural and

other factors that affect investors and their decision to buy or sell the stock. The price of the stock will fall

by the dividend amount, so in the case of Apple, it will go from $340 to $447 assuming a $3 dividend.

However, empirically we observe that whenever a company declares a special dividend, their stock price

rises by an average of 3% based on tech companies like Microsoft and Google. Appendix 4 provides a

detailed impact on varying share price but as we can see from this, even in the best-case scenario of a 5%

increase which is optimistic for a highly developed company such as Apple, the stock price would reach a

maximum of $468.75, and shareholder value increasing by $21.75 after considering the $3 dividend less

tax. Whereas the moderate case of 3% increase results in share price at $459.81 after considering 15%

capital gains tax for the investors.

Share Repurchase

Share Repurchase is a positive move for the current shareholders because it increases per share

value and the business can retrieve its voting right at the same time. In this case, Warren Buffet strongly

supports the repurchase, believing that Apple will be better-off undertaking this alternative. Now assume

that the 1.9 billion perpetual payment will be used for the repurchase, we discount that by the cost of equity

to get present value. The current cost of equity approximates 6%, so we set the range between 4% to 8%

considering there might be a slight fluctuation in cost of equity, then divide the present value with the

current price per share to get the possible repurchase amount.

For shareholders, tax expense will incur based on the amount of income they receive from the sale

of each share. In the U.S., capital gains should be taxed at approximately 15%, the following table shows

the per share gain net of tax. We use the estimated price after the repurchase to deduct IPO price, and

calculate the tax expense based on the gain. The share price after the repurchase will also increase as it

follows the rules of share repurchase. Assuming Apple maintains their P/E ratio to 10x, we can recalculate
the share price. The shareholders value will increase significantly even after the taxation. A detailed

calculation can be found in Appendix 5 but we can observe that in the moderate assume of 6% equity cost,

the shareholders’ value has increased significantly.

Evaluation of Alternatives

A common cost that is associated with all the alternatives is the cost of transferring the funds from

Ireland to the United States and hence is assumed to be constant for all.

One-time dividends are an easy way for Apple to distribute the cash they have in hand. The

advantages with it are that there aren’t high agency costs associated with it and that the firm has been doing

well and will do so for the future. The disadvantage of it are that it does not necessarily create high value

for the shareholders. Apart from that, investors may expect Apple to continue paying high dividends in the

future which creates undue expectations, leading to a potential fall in share price.

iPrefs offers a solution for Apple wherein the issuance of these preference shares to the current

shareholders will increase their value for shares as discussed before. It gives the holders of these instruments

the added advantage of being higher in seniority compared to equity shareholders although in Apple’s case

it is highly unlikely that this option will be exercised in the foreseeable future. On the other hand, it does

not produce extra value for the company and the shareholders may prefer holding the stock building on its

long-term gains. It also increases the WACC of the firm as they now have another cash obligation, preferred

dividends. This may affect the valuation of Apple.

In the case of Share Repurchases, it increases the value and the voting rights for the shareholders

after the repurchase. The tax obligations in case of a share repurchase are also lesser when compared to a

dividend pay-out, preferred or equity as dividend tax rate is higher than capital gains. Since there are lesser

shares outstanding, the EPS will increase which will increase the shareholders’ value. On the contrary,

share repurchase is a more expensive alternative than the others due to various fees involved with it. Since

one-time dividends do not add high value even after accounting tax implications for the other options, we

will focus on repurchase and iPrefs.

Conclusion

Based on all the analysis, we can summarize the following results. The share price in case of stock

repurchase is estimated to be $486.21 whereas in case of issuance of iPrefs it is estimated to be $479.70.

The return on equity for stock repurchase is ~33.39% compared to ~31.91% for issue of iPrefs (Appendix

6). Hence, upon evaluating Warren Buffet’s proposal and Einhorn’s proposal, our recommendation is to go

ahead with the Stock Repurchase as it adds more shareholder value especially in the long run.
Appendix

Appendix 1

● RWACC is the weighted average cost of capital

● RE is the cost of equity.

● R0 is the cost of the firm's unlevered equity.

● RD is the cost of the firm's debt.

● D and E are the market values of the firm's debt

and equity respectively.

Appendix 2

Appendix 3
Appendix 4

Share Price for Potential Increase (After Dividend Declaration)

1.00% 2.00% 3.00% 4.00% 5.00%
Share Price ($447) $ 451.47 $ 455.94 $ 460.41 $ 464.88 $ 469.35
Tax $ 0.60 $ 0.60 $ 0.60 $ 0.60 $ 0.60
Share Price $ 450.87 $ 455.34 $ 459.81 $ 464.28 $ 468.75
Shareholder Value $ 453.87 $ 458.34 $ 462.81 $ 467.28 $ 471.75

Appendix 5

Share Price for Varying Cost of Equity

Cost of Equity 4.00% 5.00% 6.00% 7.00% 8.00%
PV of Equity 47,500,000,000 38,000,000,000 31,666,666,667 27,142,857,143 23,750,000,000
Repurchase O/S 105,555,556 84,444,444 70,370,370 60,317,460 52,777,778
Tax (15%) 72.69 70.82 69.63 68.80 68.19
Price (After Tax) 433.90 423.33 416.57 411.88 408.43
New EPS 50.66 49.42 48.62 48.07 47.66
Price (Using 10x) $ 506.59 $ 494.16 $ 486.21 $ 480.68 $ 476.62

Appendix 6
Reference list:

1. Long term and short term capital gains: https://www.investopedia.com/articles/personal-

finance/101515/comparing-longterm-vs-shortterm-capital-gain-tax-rates.asp

2. Top mutual fund holders of Apple https://www.investopedia.com/articles/investing/090215/4-

mutual-funds-hold-apple-stock.asp

3. David Einhorn’s massive presentation on what apple should do

https://www.businessinsider.com/greenlight-capitals-apple-presentation-2013-2#here-is-the-

math-on-distributing-5-iprefs-per-apple-share-it-shows-the-reduction-in-net-income-available-to-

the-common-stock-and-earnings-per-share-distributing-5-iprefs-per-apple-common-share-results-

in-95-billion-in-additional-dividends-or-10-per-common-share-this-reduces-apples-earnings-per-

share-from-45-to-35-at-a-constant-pe-multiple-of-100x-the-new-apple-price-is-350-or-100-less-

than-the-current-price-of-450-37

4. Preferred shares

https://corporatefinanceinstitute.com/resources/knowledge/finance/preferred-

shares/#:~:text=Preference%20in%20dividends%3A%20Preferred%20shareholders,to%20vote%

20on%20extraordinary%20events