Amazon, and Whether the Company Should Approve

¶ … Amazon, and whether the company should approve the project or not. There are a number of different steps leading to this decision, and it is those steps that make up the bulk of this paper. The first step is that the capital structure of the company needs to be determined. This is going to contribute to a weighted average cost of capital calculation later on. There are two different ways of calculating capital structure, the book value method and the market value method. Both are calculated, but eventually it is the book value method that is used.

The next step is to calculate the weighted average cost of capital. In this section, we already have the weights, but we need the cost of debt and the cost of equity. These are both analyzed using market information for debt and equity alike. Three different methods of calculating the cost of equity are used -- the CAPM, the discounted cash flow model and the bond yield plus risk premium model. The CAPM figure is what is used eventually to calculate the WACC.

The final step in this process is to analyze the different cash flows. Once the cash flows are sorted out, they are discounted using the WACC. Ultimately, this project is accepted because it has a positive NPV.

Task 1 -- Estimate the Capital Structure

The capital structure of a company is the ratios of debt and equity by which it finances its operations. My company, Amazon, is financed in terms of its book value predominantly with debt, but in terms of its market value mostly by equity. This section of the analysis will take a look at the capital structure of Amazon, which is essentially for providing key elements of the weighted average cost of capital, itself important for any sort of discounted cash flow analysis for capital budgeting.

The first method for determining the capital structure of the company is to take the book values of the debt and equity. The total value of the firm is the equity plus the debt, and the objective here is just to find out how much of each is used. According to the spreadsheet, which has the values for Amazon's balance sheet, the value of the debt is $24,363 million and the value of the equity is $8,192 million. The total value of the company, therefore, is $32,550 million. When translated into percentages, these figures reveal the capital structure of Amazon.com. The company has financed its operations from 75% debt and 25% of equity. The book value is a good way to analyze the capital structure because firms normally pay attention to their capital structure, and try to find the optimal one (Investopedia, 2013). The company therefore has made a conscious decision with regards to how much equity and how much debt it has, so the book value method is the one that reflects deliberate choices of the management of the company to manipulate its capital structure and therefore also its cost of capital. If book value is good enough for the company's management, it is good enough for this report as well. It should be noted also that preferred shares would be included in this calculation if the company had any, which in this case Amazon does not.

The market value method for capital structure is based on the market value of the company's debt and equity securities. The market value of the equity is actually very easy to determine because it is the price of a share of the firm's stock multiplied by the number of shares outstanding. This is the market capitalization, which can be found on any financial website (MSN Moneycentral, 2013). So the market capitalization for Amaozn.com is $118, 500 million. The market value of the company's debt is a little bit more complicated. Given the low interest rates, it is reasonable to assume for simplicity's sake that short-term debt has book value as its value on the market. Long-term bonds, however, are subject to market pricing. Yahoo (2013) lists all three of Amazon's bond issues and the going price for them. So the Yahoo annual report highlights the different bond issues and there are three.

The company has $750 million in 2015 bonds, $1.0 billion in 2017 bonds and finally it has $1.25 billion in 2022 bonds. The price of these bonds is listed as being $100.34 for the 2022s, $101.39 for the 17s and $101.75 for the 15s. The best course of action is to weigh these and get a weighted average cost of debt. The total comes to $3 billion for the different bond issues. This is not the exact figure, however. The different figures, multiplied by the price of the bonds, will give us the market value of the debt for Amazon.

MV debt = (1.0175*750) + (1.0139 * 1000) + (1.0034 * 1250) = $3.031 billion.

The rest of the long-term debt on the balance sheet can be taken at book value for simplicity's sake -- it is not likely to make a big difference in the final numbers. The result of this is that the market value of the debt is like this:

MVdebt = Current liabilities + long-term bonds + long-term debt

= $19.002 + $3.031 + $2.277 = $24, 130 million.

At this point we can take the market value weights. The total market value of Amazon is $24.13 + $118.5 = $142.63 billion, of which 83% is equity and 17% is debt. As noted, there are significant differences between the two approaches. Market value in particular relies on market pricing, which can be quite different than book value. Amazon does not pay dividends, so people buy the company's stock looking for capital gains. That is going to make a difference in the company's valuation because it is not just about rational cash flows. For this work, it is probably better to use the book value weightings, because that is what the company would consider to be its capital structure.

WACC

No author (2013) points out that the weighted average cost of capital is what the corporation must pay out for its capital, to all of its security holders, when the weights and rates are taken into consideration. The weighted average cost of capital formula takes into account two things. It takes into account the weightings that we have just calculated above in the capital structure section, and it takes into account the cost of capital.

The first thing with the cost of debt is that it has already been calculated -- what the company pays on its bonds is a pretty good idea of what its debt is valued at. Thus, the cost of debt to be used in this calculation is 100.32 based on the weighted average of the different bonds that are on the market right now, or 1.59% yield. The cost of equity can be calculated in a number of different ways, including the capital asset pricing model -- which is CAPM, the discounted cash flow model and the bond yield plus risk premium (BYPRP) approach. This paper will examine each approach to help to understand the firm's cost of equity, before plugging all of this into the WACC calculation.

The capital asset pricing model has the formula of Ra = Rf + B (Rm-Rf). In this, the Rf is the risk-free rate, the Rm is the market risk and the B. is the beta of the company. We can find out the beta by looking at financial website, where we learn that the beta of Amazon is 0.83. The next step is to find out the risk free rate. This is going to be the same as the rate for a one-year Treasury security. Treasuries are the risk free securities because the U.S. Treasury has the ability to print money. You will literally be repaid every time, even if the real value of that repayment is not very much. In this case, the one-year risk free rate is somewhere in the range of 0.13%. The paper instructions explain that the market risk premium is between 6-8%, so we will split down the middle and use 7%. . Given all of this, the CAPM evaluation of the cost of equity for Amazon.com is like this:

Amazon = 0.13 + 0.83*(7-.13) or 0.13 + 5.7%, for a total of 5.83%.

The second method is the discounted cash flow approach. This approach assumes that investors want to buy Amazon for the cash flow that they will receive. If the company has no dividends this means that the investors are assuming future dividends, because rational investors would not chase after capital gains. With Amazon, they apparently do. There are no dividends and there are no plans for the company to begin paying dividends. As such, the discounted cash flow models cannot work.

The next model to use is the bond yield plus risk premium. This is because the company's risk is assessed by the bond markets, but there must also be a risk premium for holding equity because shareholders are subordinated to debt holders. In this situation with Amazon, the company has an average bond yield that can be calculated. The yields on its bonds are, in order of maturity, 0.639%, 1.184% and 2.492%. This gives an average bond yield of 1.59%. We also know the market risk premium is 7%, a figure we will use for consistency purposes. The result is simple: 7 + 1.59 = 8.59%. This is a reasonable number to work with, but it is not as good as the CAPM number. The reason is that this figure tries to relate the value of equity to the value of debt. The capital asset pricing model relates the value of equity to the risk characteristics of the equity, not the risk characteristics of the company's bonds. This is a significant different.

At this point we have the cost of equity, the cost of debt and the weightings for each of these things. We are officially ready to do this. The WACC calculation at this point is a straightforward weighted average calculation. It goes like this:

(.75) (1.59) + (.25) (5.83) = 2.65%

The Cash Flow Estimation

The cash flow estimation is an important aspect of the capital budgeting process because at this point we have the cost of capital. We just need to discount the value of the future cash flows. We have some costs known already, like $180 million for the initial expense and the $12 million on the install. When this is depreciated, that is important. The depreciation is based only on the initial cost -- one would not include the cost of the installation in this calculation. So what we have is something that is depreciation over six years using the MACRS formulas provided in the case. We must not deduct depreciation because a discounted cash flow analysis really only takes into account cash flows. Depreciation is not a cash flow. So why worry about it? Because depreciation is a tax benefit. It reduces net income, so we need to factor that into the equation because when less tax is paid, that is a cash flow. Here is what the depreciation looks like, using the 33% tax rate from the case:

Depreciation

Total

1

2

3

4

5

6

Rate

0.20

0.32

0.19

0.12

0.11

0.06

Amount

36.00

57.60

34.20

21.60

19.80

10.80

Tax Benefit

11.88

19.01

11.29

7.13

6.53

3.56

Tax rate

0.33

The other cash flows that need to be taken into account are the revenues, the costs and the taxes. All of these are pretty straightforward. We start with unit demand projections, factor in the revenue and variable costs for those, and then what will be taxed. There will also be salvage value and the change in working capital to take into consideration. All of these cash flows must be discounted back to present value, and this is done using the discount rate that we have already calculated: