Step 1 - Compute reinvestment rate and estimate growth in EBIT

We started by considering the FCFF for the current year. However, for the base year´s EBIT, we
did some adjustments to clean up earnings:

- We used EBIT adjusted for leases.

- We categorized R&D as operating (instead of capital) expenses.

By doing this, we get an improved insight of how much capital was invested by Apple and how
much return is being generated by that capital.

Using the FCFF for the base year, we can compute the reinvestment rate by using the following
formula:

Reinvestment rate = (Capex – Depreciation + Change in Working Capital) / (EBIT(1-t)) = 8.84%

In order to estimate growth in EBIT, we firstly had to estimate the Return on Capital for the
base year:

Return on Capital = (EBIT(1-t)) / (BV of Equity + BV of Debt – Cash and Cash equivalents –
Current marketable securities) = 38.28%

Why only cash and current marketable securities? Find argument

Using the Return on Capital and the Reinvestment rate, we could estimate growth in EBIT:

Expected growth rate in EBIT = Reinvestment rate * Return on Capital = 3.38%

We decided to divide our valuation process into 3 different phases with different inputs: high
growth phase (5 years), transition phase (5 years) and a stable growth phase (forever after 10
years).

Step 2 – Estimate inputs for each phase

For the high growth phase (Year 1 to Year 5), we assumed that the Reinvestment Rate, Return
on Capital and, consequently, expected growth in EBIT remain unaltered. It is, essentially, the
same firm for 5 more years.

Between years 5 and 10 (transition phase), growth will start declining. We assumed a linear
decline until converging with the risk-free rate (1.73%). The company will grow at the risk-free
rate after the 10th year (stable growth phase).

Analysing Return on Capital, Apple has very strong competitive advantages namely the brand
name. We believe that these advantages are very unlikely to entirely disperse in the near
future allowing Apple to keep a 15% Return on Capital in the long term. Considering the
estimates in Step 3, returns will be higher than the cost of capital in perpetuity. During the
transition phase, the Return on Capital will decay linearly.

Taking into account the expected growth rate and return on capital in perpetuity (1.73% and
15%, respectively), we can compute the reinvestment rate for the stable growth phase:

Reinvestment rate = Growth rate in EBIT / Return on Capital = 1.73% / 15% = 11.5%

We conclude that in order to keep a 1.73% growth forever with a 15% return, Apple needs to
reinvest 11.5%
We also assumed that the tax rate does not change.

These inputs are summarized in the table below:

High growth phase Transition phase Stable growth period

Length of period 5y 5y Forever after 10y
Tax rate 15.90% 15.90% 15.90%
Return on capital 38.28% Declines linearly to 15% 15%
Reinvestment rate 8.84% Gradually to 11.5% Reinvestment rate =
g/ROC = 11.5%
Expected growth ROC * Reinvestment rate Linear decline to stable 1.73%
rate in EBIT = 3.38% growth rate of 1.73%

Debt/capital ratio 10.68% Rises linearly to 20% 20%

Risk parameters Beta=1.25, ke=8.66% Beta changes to 1.00 Beta = 1.00
Pre-tax cost of debt = Cost of debt stays at Ke = 7.27%
2.36% 2.36% Cost of debt stays at
Cost of capital = 7.94% Cost of capital declines 2.36%
gradually to 6.21% Cost of capital = 6.21%

Step 3 – Estimate risk parameters for each phase

Step 4 – Compute Terminal Value

Using the terminal growth rate and reinvestment rate at stable growth, we initially started by
computing the free cash flow to the firm for the 11 th year:

FCFF11 = EBIT10(1-t) * (1+gn) (1-Reinvestment rateStable growth) = $73077 million

Afterwards, we calculated the terminal value as follows:

TV = FCFF11 / (Cost of capitalstable growth -gn)

Step 5 – Compute Value of Equity

Initially, we computed the value of the firm by adding the following elements:

Value of the firm = PV of cash flows Year 1-10 + PV of terminal value + Cash and marketable
securities + Nonoperating assets

Subsequently, we found the value of equity in common stock:

Value of equity in common stock = Value of the firm – Debt – Minority interests – Equity
options

We could then find the price/share dividing the value of equity by the number of shares.

By comparing this price with the current market price, we can conclude if Apple is overvalued
or undervalued.