An Investment Analysis Case Study

The Setting Apple Inc. has had a very good run, both in terms of earnings and stock prices, over the last
decade. Based largely on the success of the iPod, the iPhone and the iPad, the company has reported
double digit growth in revenues and earnings over the last few years (see exhibit 1) and its stock price has
reflected this success (see exhibit 2). It has a substantial cash balance and a strong balance sheet (see
exhibit 3 for balance sheet information). However, Tim Cook, CEO of Apple, is concerned that the halcyon
days of the iPhone are coming to an end and is under pressure from financial markets to come up a new
product in a big market.

The Proposal

Apple is considering entering the automobile market with an innovatively designed electric car, called the
iCar, aimed at the premium end of the automobile market. You have been asked to collect the data to
make the assessment and have come back with the following information:

1. R&D Expenses: Apple has already spent (and expensed) $ 5 billion on research on the automotive
technology and development of the commercial design. None of that money can be recouped at this
stage, if Apple decides not to go ahead with the iCar.

2. Introductory Costs; If Apple decides to go ahead with the iCar investment, it will have to spend $22
billion up front (right now) to lock in suppliers, distributors and retailers and to invest in infrastructure.
The cost is depreciable over the next 10 years, down to a salvage value of $ 2 billion, and Apple expects
to use straight-line depreciation.

3. Market Potential and Share: In the premium auto market (including all cars priced at or above $60,000)
there were 5 million automobiles sold globally in the most recent year and the market is expected to grow
approximately 4% a year for the next decade. Apple expects to gain a 2% market share next year if the
iCar is introduced and increase that market share by 2% a year (4% in the second year, 6% in the third
year, 8% in the fourth year and 10% in year 5) to reach a target market share of 10% of the overall market
by the fifth year. It expects to maintain that market share beyond year 6.

4. Pricing and Unit Costs: Apple expects to price its cars at $ 75,000 a unit next year and the price will keep
pace with inflation after that. Based upon the costs of the the materials used in the iCar currently, Apple
expects the production cost per unit to be $ 50,000 next year and grow at the inflation rate thereafter.

5. Marketing Options and Costs: Apple plans to use two different retailing options. In the first, it will sell
the iCar through auto retailers and pay the retailers a commission of 10% of the price per unit sold (The
retailers will have to follow Apple’s fixed price schedule – no discounting allowed). In the second, it will
sell the iCar through the Apple Auto Stores around the country. To do the latter, Apple will have to spend
$5 billion right now in creating the stores; this expense will be depreciated straight line over the next 10
years to a salvage value of zero. It will also pay its sales people a commission of 5% of the price per unit
for every car sold at an Apple Auto store. Apple expects to generate 80% of its revenues from specialty
retailers and 20% from Apple Auto Store sales each year for the next 10 years.

6. Geographical breakdown: Apple expects to get its revenues from the iCar globally, with the following
breakdown for revenues:

Region % of Revenues
 Africa 2.00%

Asia 30.00%

Australia & New Zealand 8.00%

Central and South America 10.00%

Eastern Europe & Russia 5.00%

Middle East 5.00%

North America 25.00%

Western Europe 15.00%

Apple expects this revenue breakdown for the iCar to be stable over time. The regional country risk
premiums (over and above the mature market premium) are provided in exhibit 4. You can assume that
the premium for mature markets (Aaa rated countries) is 5.75%.

7. Production Facilities and Costs: Apple currently uses a manufacturing facility in Singapore to make
batteries for its devices (iPhone, iPod and iPad). Apple used only 40% of the facility in the most recent
year but the device market is expected to grow 12% a year for the next 10 years. If Apple goes ahead with
the iCar, it will use the excess capacity to produce batteries for the iCar, with every 10,000 iCar batteries
using 1% of the capacity. (Thus, in a given year, if 200,000 iCars are produced, it will take up 20% of the
total capacity of the battery factory). If the capacity limit is reached, Apple will have to invest a substantial
amount to create a new facility of equivalent capacity. The current estimate of the cost of building a new
facility is $ 5 billion, but this cost will grow at the inflation rate.

8. G&A expenses: Apple will allocate 10% of its existing general and administrative costs to the new
division. These costs total $ 7.5 billion for the entire firm in the most recent year and are expected to grow
5% a year for the next 10 years, with or without the iCar investment. In addition, it is expected that Apple
will have an increase of $ 0.5 billion in general and administrative costs next year when Apple iCar is
introduced, and this amount will grow with the new division’s dollar revenues after that. The latter cost
is directly related to the new iCar division.

9. Advertising Expenses: Apple spent $ 8 billion on advertising in the most recent year. If Apple does not
invest in the iCar, it expects this cost to increase 5% a year for the next 10 years. If the iCar is introduced,
the total advertising expenses each year, from years 1 to 10, are expected to be 15% higher than they
would have been without the iCar division.

10. Working Capital: The iCar will create working capital needs, which you have estimated as follows:

 The sale of iCars to retailers will create accounts receivable amounting to 5% of revenues each
year.
 Inventory (of both the input material and finished iCars) will be approximately 10% of the variable
production cost (not including depreciation, marketing costs, allocations or advertising expenses).
 Accounts payable will be 6% of the variable production cost (not including depreciation,
marketing costs, allocations or advertising expenses).
 All of these working capital investments will have to be made at the beginning of each year in
which goods are sold. Thus, the working capital investment for the first year will have to be made
at the beginning of the first year.

11. Side benefits for device sales: If Apple goes ahead with the Apple iCar, it will see revenues for the
iPhone and iPad increase by $2 billion next year (as they are integrated into the iCar), and grow at the
inflation rate after that. The after-tax operating margin (after tax operating income/ revenues) is 40% for
all Apple devices (iPads and iPhones).

12. Risk Measures: The beta for Apple is 0.79, calculated using weekly returns over the last 2 years and
against the S&P 500 Index and 0.95 against the MSCI Global Index(see exhibit 5). Apple currently gets
about 56% of its revenues from smartphones/tablets, 25% from computers and 19% from retail. The
details of the beta calculation are included in Exhibit 5, as well as bottom up beta estimates for each of
the three businesses of Apple. The current stock price for the firm is $ 128.85/share and there are 5,824.5
million shares outstanding.

13. Debt Choices: Apple expects to finance the iCar division using the same mix of debt and equity (in
market value terms) as it is using currently in the rest of its business. Apple’s currently has $36.4 billion in
book value of interest bearing debt (with a weighted average maturity of 5 years) and it reports the
following lease commitments for the future:

Year Lease commitment

2015 $ 662 million

2016 $ 676 million

2017 $ 645 million

2018 $ 593 million

2019 $ 534 million

Beyond $ 1,877 million

The lease payment for the most recent year is $717 million. Apple was rated AA+ and the default spread
for companies with that rating is 0.50%.

14. Taxes: Apple’s effective tax rate is 26%, but its marginal tax rate is 40%.

15. Macro data: The current long-term US Treasury bond rate is 2.0%, and the expected inflation rate is
1.5%.

16. Other information: You have collected information on other automobile companies in Exhibit 6. The
data includes the regression betas of these companies and relevant information on both market values of
debt, equity and cash. You can assume a 40% 6 marginal tax rate for these firms, as well. (You can also
assume that the debt includes the present value of operating leases).
Questions on the Project

1. Accounting Return Analysis

 Estimate the operating income from the proposed iCar investment to Apple over the next
10 years.
 Estimate the after-tax return on capital for the investment over the 10-year period.
 Based upon the after-tax return on capital, would you accept or reject this project?

This will require you to make some assumptions about allocation and expensing. Make your
assumptions as consistent as you can and estimate the return on capital.

2. Cash Flow Analysis

 Estimate the after-tax incremental cash flows from the proposed iCar investment to Apple
over the next 10 years.
 If the project is terminated at the end of the 10th year, and both working capital and
investment in other assets can be sold for book value at the end of that year, estimate
the net present value of this project to Apple. Develop a net present value profile and
estimate the internal rate of return for this project.
 If the iCar division is expected to have a life much longer than 10 years, estimate the net
present value of this project, making reasonable assumptions about investments needed
and cash flows. Develop a net present value profile and estimate the internal rate of
return for this project.
3. Sensitivity Analysis
 Estimate the sensitivity of your numbers to changes in at least three of the key
assumptions underlying the analysis (You get to pick what you think are the three key
assumptions).

Based upon your analysis, and any other considerations you might have, tell me whether you
would accept this project or reject it. Explain, briefly, your decision.