Introduction
One of the factors that have led to increased cash holdings among US companies is the need to avoid a cash squeeze that may occur in the event of a reduction in external sources of funding. However, some investors believe that their companies should not hold excess cash. Specifically, they believe that excess cash should be used to finance share repurchase programs or be distributed as dividends to improve shareholder value (Grullon & Michaely 2004, pp. 651-680). This paper will highlight the reasons why investors are worried about companies that hold too much cash. In addition, it will discuss the funding option that Apple should use to repurchase its shares.
Why Investors are Against Holding Too Much Cash
A company is said to have too much cash if the level of its cash holdings exceeds that needed to finance its projects that have net positive present value (Tirole 2010, p. 89). Generally, a company’s cash balance is considered to be excessive if it exceeds the amount required to finance working capital. Cash holdings often increase as the company reduces its capital expenditure due to a decline in investment opportunities. In addition, improved operational performance in terms of persistent increase in profits and reduction in costs can lead to excess cash holdings.
Investors are concerned about excess cash holdings due to the following reasons. First, excess cash reduces shareholder value by reducing the company’s returns on assets (ROA). Most companies invest excess cash in riskless assets such as treasury bills and commercial papers. These investments often have very low returns due to their low-risk profiles. Thus, if a company holds excess cash the value of its total assets will be high, but its returns will be below. Consequently, the ROA will decline and the company will be considered to be underperforming (Tirole 2010, p. 89). In his regard, investors will incur capital losses as the company’s share price reduces.
Second, investors fear that excess cash can be misused by managers. According to the free cash flow theory, excess cash holdings can lead to overinvestment since it increases the number of resources under the control of managers (Lee & Suh 2011, pp. 1306-1329). The executives of a firm have been motivated to invest to increase the company’s financial performance. Improved performance benefits the executives through rewards such as promotions, salary increments, and bonus pay (Howe, He & Wenchi & 1992, pp. 1963-1975). Overinvestment is likely to occur if the company is operating in an industry with limited investment opportunities. In this case, managers may invest in projects that have negative net present value. These include mergers and acquisitions whose costs of capital exceed the returns.
Third, some investors prefer dividends to excess cash holdings. The gist of this perspective is that distributing excess cash as dividends enable investors to seek higher returns by investing their money in alternative investments (Tirole 2010, p. 114). Furthermore, using the excess cash to pay dividends is considered a means of attracting new investors. When new investors join the company, the share price is likely to increase and the company’s ability to access funding through the equity market improves.
Fourth, excess cash increases the company’s cost of capital (COC). The company becomes less attractive to investors and lenders if its COC is consistently higher than its ROA. As a result, the company will have limited access to external capital (Brown & Petersen 2011, pp. 694-709). In addition, a high cost of capital reduces the company’s market value. Finally, investors oppose holding excess cash because it can lead to overconfidence and failure on the part of the company’s executives. Excess cash represents past successes rather than present or future capabilities. Moreover, managers can use the excess cash to cover up their mistakes rather than to find effective solutions to the challenges facing the business.
Funding Share Repurchase at Apple
Apple should fund its share repurchase program by issuing a new bond due to the following reasons. First, the company’s current gearing ratio (debt/equity) is only 0.13. Since the company’s debt level is low, it can borrow more cash to finance share repurchase without negatively affecting its profits. In 2013, the company realized a pre-tax profit margin of 33.2% (Apple 2013). This implies that the company is financially healthy and is likely to pay its debts in the future. Repurchasing the shares by issuing a new bond will increase the company’s debt. However, it will enable the company to reduce its cost of capital, which is currently higher than the industry level (Apple 2013). A low cost of capital will improve shareholder value as the market price the company’s stock more favorably. As a result, investors will benefit from improved share prices.
Second, funding the share repurchase program by issuing a bond is justified by the tax benefits associated with it. Currently, a large proportion of Apple’s excess cash is held in overseas subsidiaries, thereby enabling the company to avoid paying high taxes. If the excess cash is repatriated to the US to finance the share repurchase program, the company’s effective tax liability will increase from the current 26% to 35% (Apple 2013). This will significantly reduce the companies tax profits. In addition, the equity market’s reaction to the reduction in the after-tax profits can lead to a significant decline in share price. Issuing a bond, on the other hand, is beneficial because the interest paid on the debt is tax-deductible. This will enable the company to save by reducing its tax liability.
Third, using a new bond issue to finance the share repurchase program will promote efficiency and accountability in the company. A corporate bond is a debt instrument, which the company has to pay in the future. Failure to repay the principal amount of the bond and the interest will result in dire consequences such as bankruptcy suits and loss of investor confidence in the company (Tirole 2010, p. 122). To avoid these consequences, the company’s executives and the board of directors will have to put in place measures to improve the firm’s profits and to reduce costs. This will enable the company to access the cash that it requires to meet its debt obligations in time. In addition, the expected improvement in corporate governance will enhance the performance of the company through improved accountability, transparency, and leadership.
Fourth, using a new bond issue to repurchase shares will enable Apple to use its huge cash reserves to increase its competitiveness in the industry. Currently, Apple is facing high competition from its main rivals such as Samsung and LG who are competing based on price and product quality. To overcome the competition, Apple has to maintain a high product quality standard and reduce the prices of its products to attract new customers. This strategy will require heavy investments in an efficient distribution network, advertising, low-cost production centers, and employing the best talent in the industry. These investments can be financed by the company’s excess cash rather than debts to avoid increasing operating costs. According to (Fresard 2010, pp. 1097-1120), firms that hold significantly higher cash reserves than their rivals often increase their market shares by up to 2.9% over the next two years. This positive cash effect is likely to be higher in the technology industry in which Apple operates due to its competitive nature.
Apple can also use its excess cash as a weapon to distort its rivals’ strategies. The company’s huge cash reserves can be a barrier to entry into the industry since new entrants may not have the adequate financial capital to compete with the incumbents effectively (Fresard 2010, pp. 1097-1120). This will enable the company to defend or increase its market share. Similarly, the company can use its excess cash as a threat of competitive retaliation in the industry. Rival firms such as Samsung and LG will be reluctant to increase their production capacities if they know that Apple can react to their decisions by expanding its capacity. This will enable Apple to avoid a decline in its profit margins as it reduces the prices of its products to increase sales when the industry has excess capacity.
Finally, issuing a new bond to repurchase the shares will enable Apple to utilize its excess cash reserves to finance research and development projects. Undoubtedly, Apple owes its success to research and innovation that enabled it to develop new products such as iPhones and iPads that continue to be its main source of revenue. To maintain high growth through innovation, the company must be able to access large amounts of financial capital to finance research and development. Given the fluctuations in interest rates and availability of credit, relying on an external source of funding will limit the company’s ability to finance research and development projects (Lins, Servaes & Tufano 2010, pp. 160-176). In this regard, retaining the excess cash reserve will be better than using them to finance the repurchase of shares. The rationale of this perspective is that investors might not benefit from the share repurchase program through stock price appreciation if the market under-reacts (Chan, Ikenberry, Lee & Wang 2005, pp. 137-158). However, using the cash to develop new innovative products will improve the company’s revenue and shareholder value.
Conclusion
Holding excess cash is associated with both positive and negative effects on firm performance. The negative consequences include increasing the cost of capital, overinvestment, and reducing returns on assets. On the other hand, excess cash can be used to improve the company’s competitiveness through developing new products and distorting competitors’ marketing strategies. Apple should finance its share repurchase program by issuing a new bond to reduce its cost of capital and to promote efficiency. Moreover, issuing a bond will enable Apple to use its cash reserves to boost its competitiveness.
References
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