Alongside Apple's earnings release last week, the company dropped a capital structure bombshell: It will be tapping the debt markets to raise cash. This has been a topic of debate for some time, since Apple's cash balance has reached legendary status.
Some investors may initially think the move counterproductive: Why raise debt when you have cash?
The first reason is that the bulk of Apple's cash -- $102.3 billion to be precise -- is currently held overseas by foreign subsidiaries. Apple would face quite a tax bill if it wanted to repatriate those dollars back home.
Source: SEC filings. Calendar quarters shown. MRQ = most recent quarter.
At the same time, investors have been demanding thatApple return more cash, so the only way to balance those two interests is to tap debt markets to raise domestic cash.
The other benefit to Apple of raising debt is to reduce the company's weighted average cost of capital, or WACC. How much of a benefit are investors possibly looking at? Let's start with the WACC formula.
Figuring out Apple's current WACC is fairly straightforward, because it currently has no debt. Using the capital asset pricing model, I estimate Apple's current cost of equity at 8.5%, lower than my February estimate of 10.5%. This is because Apple's volatility (measured by beta) has declined and the risk-free rate (measured by 10-year Treasury yields) has also declined. The equity risk premium is largely unchanged.
With no debt, Apple's current WACC is simply its cost of equity, or 8.5%. Let's now add in some debt.
Lever up, WACC down
The (1-t) component above represents the tax break that comes with debt, since interest expense is tax-deductible. Like all American corporations, Apple faces a statutory federal income tax rate of 35%, which is what applies here. Apple's effective tax rate is much lower (around 26%), in part because of keeping foreign earnings "indefinitely reinvested" abroad.
As far as estimating the cost of debt, let's say that Apple issues paper with a 2.25% coupon. That would be slightly higher than 10-year Treasuries (Apple carries the same credit rating as the U.S. government) as well as the 1.25% that IBM borrowed at earlier this year.
Using these estimates, this is how differing amounts of debt raised would affect Apple's WACC right now.
Annual Interest Expense
Source: Author's calculations.
If Apple raised up to $100 billion in debt, it could realize a WACC reduction as high as 1.5%. Realistically, though, the company will sell between $40 billion and $60 billion in paper, because it still generates operating cash flow domestically. Apple's generated $6.2 billion in cash domestically over the past year, which is after paying out $9.4 billion in dividends and buybacks so far.
It may be an implicit gain shrouded in financial theory, but Apple investors can look forward to seeing Apple's overall cost of capital come down.
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The article This Is Exactly How Much Debt Will Help Apple originally appeared on Fool.com.
Fool contributor Evan Niu, CFA, owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.