This paper presents a structured capital budgeting analysis for Amazon, walking through three sequential tasks: estimating capital structure using both book value and market value methods, calculating the weighted average cost of capital (WACC) using the CAPM, discounted cash flow, and bond yield plus risk premium approaches, and evaluating a proposed project's future cash flows through net present value (NPV), internal rate of return (IRR), profitability index (PI), and payback period analysis. The analysis concludes that the project should be accepted, as it yields a positive NPV, an IRR well above the discount rate, and a PI above 1.0, all of which signal significant value creation for Amazon's shareholders.
The paper demonstrates methodological triangulation in financial analysis — applying three separate cost-of-equity models and four separate project evaluation criteria (NPV, IRR, PI, payback period) to cross-validate a single investment decision. This approach strengthens the conclusion by showing that no single metric is relied upon in isolation.
The paper opens with a brief overview of its three-part structure, then moves sequentially through each task. The capital structure section computes book and market value weights before selecting the book value approach. The WACC section works through all three cost-of-equity methods before settling on CAPM. The cash flow section introduces a depreciation tax shield analysis, presents a multi-year cash flow table, and summarizes all four evaluation metrics. The conclusion is brief and ties results back to shareholder value creation.
This paper presents a capital budgeting analysis for Amazon, examining whether the company should approve a proposed investment project. There are a number of sequential steps leading to this decision, and those steps make up the bulk of the analysis. The first step is to determine the capital structure of the company, which contributes to a weighted average cost of capital (WACC) calculation. There are two different ways of calculating capital structure — the book value method and the market value method. Both are calculated, but ultimately the book value method is used.
The next step is to calculate the weighted average cost of capital. In this section, the weights have already been established through the capital structure analysis, but the cost of debt and the cost of equity still need to be determined. These are analyzed using market information for both debt and equity. Three different methods of calculating the cost of equity are used: the Capital Asset Pricing Model (CAPM), the discounted cash flow model, and the bond yield plus risk premium (BYPRP) model. The CAPM figure is ultimately used to calculate the WACC.
The final step is to analyze the project's cash flows. Once the cash flows are identified, they are discounted using the WACC. The project is ultimately accepted because it produces a positive net present value (NPV).
The capital structure of a company is the ratio of debt and equity by which it finances its operations. Amazon is financed, in terms of book value, predominantly with debt, but in terms of market value mostly by equity. This section examines Amazon's capital structure, which is essential for identifying key inputs to the weighted average cost of capital — itself critical for any discounted cash flow analysis in capital budgeting.
The first method for determining capital structure is to use the book values of debt and equity. The total value of the firm equals equity plus debt, and the objective is simply to determine how much of each is used. According to 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 is therefore $32,550 million. Expressed as percentages, Amazon has financed its operations with 75% debt and 25% equity.
The book value method is a useful way to analyze capital structure because firms typically pay close attention to their capital structure and work to find the optimal balance (Investopedia, 2013). The company has therefore made deliberate decisions about how much equity and how much debt to carry, meaning the book value method reflects conscious choices by management to shape the firm's capital structure and, by extension, its cost of capital. If book value is considered sufficient by the company's own management, it is appropriate to use here as well. It should also be noted that preferred shares would be included in this calculation if the company had any; in Amazon's case, it 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 equity is straightforward to determine: it is the stock price multiplied by the number of shares outstanding, yielding the market capitalization (MSN Moneycentral, 2013). Amazon's market capitalization is $118,500 million. The market value of the company's debt is somewhat more complex. Given the low interest rate environment, it is reasonable to assume for simplicity that short-term debt trades at book value. Long-term bonds, however, are subject to market pricing. Yahoo Finance (2013) lists all three of Amazon's bond issues and their current market prices.
Amazon has $750 million in 2015 bonds, $1.0 billion in 2017 bonds, and $1.25 billion in 2022 bonds. The market prices are listed as $101.75 for the 2015s, $101.39 for the 2017s, and $100.34 for the 2022s. To find the market value of these bonds, each issue is multiplied by its respective price:
MV debt = (1.0175 × 750) + (1.0139 × 1,000) + (1.0034 × 1,250) = $3.031 billion
The remaining long-term debt on the balance sheet can be taken at book value for simplicity, as it is unlikely to materially affect the final figures. The total market value of Amazon's debt is therefore:
MV debt = Current liabilities + long-term bonds + long-term debt = $19.002 + $3.031 + $2.277 = $24,130 million
Using these figures, 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 depends on market pricing, which can diverge considerably from book value. Amazon does not pay dividends, meaning investors purchase the stock in pursuit of capital gains rather than cash flow, which adds a speculative component to the company's valuation. For the purposes of this analysis, the book value weightings are used, because that is what the company itself would consider to be its capital structure.
The weighted average cost of capital represents what a corporation must pay out for its capital, to all of its security holders, when weights and rates are taken into consideration (No author, 2013). The WACC formula incorporates both the weightings calculated in the capital structure section and the cost of each component of capital.
The cost of debt has effectively already been established. What the company pays on its outstanding bonds provides a reliable approximation. The weighted average yield on Amazon's publicly traded bonds is 1.59%, which will serve as the pre-tax cost of debt.
The cost of equity can be estimated in several ways, including the Capital Asset Pricing Model (CAPM), the discounted cash flow (DCF) model, and the bond yield plus risk premium (BYPRP) approach. Each method is examined in turn.
The Capital Asset Pricing Model uses the formula: Ra = Rf + β(Rm − Rf), where Rf is the risk-free rate, Rm is the expected market return, and β is the company's beta. Amazon's beta is 0.83. The risk-free rate is approximated by the one-year U.S. Treasury security rate, which is 0.13%. Treasuries are considered risk-free because the U.S. Treasury has the ability to create money, ensuring repayment under virtually any circumstance. The market risk premium, as specified in the case instructions, falls between 6% and 8%; the midpoint of 7% is used here. The CAPM cost of equity for Amazon is therefore:
Amazon cost of equity = 0.13 + 0.83 × (7 − 0.13) = 0.13 + 5.70% = 5.83%
The second method is the discounted cash flow approach. This model assumes that investors purchase stock in exchange for the cash flows they will receive. Since Amazon pays no dividends and has no announced plans to begin paying them, the DCF model cannot be meaningfully applied in this case. Rational investors would not ordinarily chase capital gains absent an expectation of future cash flows, yet Amazon's shareholders apparently do. Consequently, the DCF model is not used here.
The third method is the bond yield plus risk premium approach. This model uses the company's bond yield as a baseline assessment of the firm's overall risk, then adds an equity risk premium to account for the fact that shareholders are subordinated to debt holders. Amazon's bond yields, in order of maturity, are 0.639%, 1.184%, and 2.492%, giving an average bond yield of 1.59%. Adding the 7% market risk premium used earlier for consistency yields a cost of equity estimate of 8.59%. While this is a reasonable figure, it is less theoretically sound than the CAPM estimate because it relates the value of equity to the risk characteristics of the company's debt rather than to the risk characteristics of the equity itself. This is an important conceptual distinction. Accordingly, the CAPM figure of 5.83% is used in the WACC calculation.
With the cost of equity, cost of debt, and capital structure weights now established, the WACC calculation is as follows:
WACC = (0.75)(1.59%) + (0.25)(5.83%) = 1.19% + 1.46% = 2.65%
Investopedia. (2013). Optimal capital structure. Investopedia. Retrieved April 21, 2013 from http://www.investopedia.com/terms/o/optimal-capital-structure.asp
MSN Moneycentral. (2013). Amazon.com. Retrieved April 21, 2013 from
No author. (2013). How to determine your WACC. Structuring Finance. Retrieved April 21, 2013 from
Yahoo! Finance. (2013). Bond screener: Amazon. Retrieved April 21, 2013 from
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