Hypothetical Project of Amazon.com From the Capital Term Paper

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hypothetical project of Amazon.com from the capital budgeting perspective. The first step is to estimate the capital structure of Amazon using both the book value and market value methods, and then use this information to calculate the weighted-average cost of capital. A number of different methods are used to calculate the cost of equity. .Once the WACC has been established, a discounted cash flow analysis can be done to evaluate the project, based on the cash flows given in the case. In this situation, the analysis reveals that the project would be undertaken.

Estimate Capital Structure

The capital structure of a firm refers to "the percentage of capital at work in a business type" (Kennon, 2013). Every firm has to raise capital from somewhere in order to finance its business. The main forms are debt and equity, but sometimes hybrid forms like preferred shares are also used. In general the capital structure is the weighted-average of the debt and equity. Normally, one would use the book value to calculate the capital structure. This is the only logical value to use really because it factors in the debt that the company raised, the equity that it raised through issues, and the retained earnings that it has accumulated over the years. All of the different forms of liabilities and equity are included in this calculation, because all forms of borrowings and owners' equity are treated alike to determine the firm's capital structure.

For Amazon, the capital structure of the firm based on its book value is as follows. The company has a total firm value as of December 31, 2012 of $32.55 billion. This is found in the Total Assets line on the balance sheet. The total assets are comprised of the liabilities and the shareholders' equity. The value of the liabilities on the balance sheet of Amazon as of December 31, 2012 was $24.363 billion and the value of shareholders' equity was $8.192 billion. This means that the capital structure is 74.8% debt and 25.1% equity. Amazon.com does not have preferred shares.

Another approach to finding the capital structure of Amazon is to use market values. This approach assumes that markets are perfectly rational and therefore stock prices accurately reflect the present value of expected future cash flows. This represents a significant departure from the book value approach, which only takes into account known value in the firm -- the market value approach inherently takes into account market speculation about future value. The market value of liabilities is going to be based on the assumption that short-term liabilities are equivalent to their book value, and that long-term debt can be extrapolated to all long-term liabilities. The market value of the firm's assets is not actually relevant -- there is no matching principle and therefore no need to "balance" the market value calculation.

The market value of Amazon's stock is its market cap. As of April 19th, 2013 the market cap of Amazon is $118.5 billion. The value of short-term liabilities is $19.002 billion. The company's long-term debt is divided among three issues. These are $750 million due 2015, $1 billion due 2017 and $1.25 billion due 2022 (2012 Amazon Annual Report). According to Yahoo! Finance (2013), the prices of these bonds are 101.75, 101.39 and 100.34 respectively. Thus, the market value of the long-term debt is $763.13 million + 1013.9 million + $1,254.25 million = $3,031.28 million. The weighted average of the market value of the debt is 100.97. If that figure is applied to the remaining book value of long-term debt, it would be worth $2.299 billion. Thus, the total market value of the company's liabilities is: $19.002 + $3.031 + 2.299 = $24.332 billion. The combined market value of debt and equity is $142.83 billion, of which 17% is debt and 83% is equity. This illustrates a dramatic difference between the book value approach and the market value approach. The difference primarily derives as the result of the market value approach including expected future cash flows into the calculation, which would drive up the value of equity. This also assumes that the company will not add to its debt in the future -- while the value of equity is speculative, there is no equivalent speculation about subsequent debt issues or even debt growth due to balance sheet expansion.

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Weighted-Average Cost of Capital

The formula for the weighted-average cost of capital is as follows (Investopedia, 2013):

We have the weights for debt and equity, based on both the book value and the market value approaches. Now, we need to know the rates of return that are expected from each. The rate of return on debt can be calculated from the existing debt. In the market right now, the weighted returns on the debt would be based on the following returns: 2.492% for the 2022, 1.184% for the 2017 and 0.639% for the 2015. So the weighted-average return on the debt is (.25)(0.639)+(.33)(1.184)+(.416)(2.492) = 1.59%.

There are multiple different approaches to valuing the firm's equity. The most logical of these is the capital asset pricing model. The formula for CAPM is (QuickMBA, 2013):

re = rf + ?e ( rm -- rf )

The risk-free rate is a short-term Treasury rate. A 3-month Treasury yields 0.03%. Note that this model does not include the effects of taxation, but on 0.03% the tax effect is hardly going to be relevant. So the basic CAPM will do. The market risk premium is assumed to be 7%. The beta is 0.83 (MSN Moneycentral, 2013). Thus, the expected return on Amazon's stock is: 0.03 + (.83)(6.97) = 5.81

Another method is the discounted cash flow model. This model takes future cash flows and discounts them back to the present day. This model is often used with respect to dividends, but Amazon does not pay dividends. The investor, therefore, can assume no future cash flows from the company. Under this model, if the stock has a value, this is said to be the expectation of future dividends, which is a weak argument -- the investors are buying for capital gains. Thus, the discounted cash flow model is not a good one for Amazon.

The third approach is the bond-yield-plus-risk premium approach. The weighted-average bond yield we have established to be 1.59%. We have already established a risk premium of 7%, so the expected rate of return on the equity is 8.59% using this approach.

To calculate the weighted-average cost of capital, the book value weights will be used. The market value approach has a couple of fundamental issues that make it less desirable. The first is that it assumes perfect rationality in equities markets. The second is that the market value approach accepts future values for equities, but makes no similar allowance for the company to issue further debt, creating inconsistency in the treatment of the two options. The cost of equity that will be used derives from the capital asset pricing model. The bond yield plus risk premium model does not take into account the equity risk characteristics of Amazon (the beta) but rather of its debt. Given that the company's debt has significantly different characteristics for the investor than the equity -- such as the fact that the equity is subordinated to the debt -- it is better to base the expected rate of return on a formula that takes equity into account, rather than one that takes debt into account. The discounted cash flow model does not work because there are no guarantees of any future cash flows -- investors are still valuing Amazon based on expected capital gains, which are purely speculative. Thus, the weighted average cost of capital for Amazon is as follows:

(.748)(1.59) + (.251)(5.81) = 2.647%

Cash Flow Estimation and Capital Budgeting Analysis

Armed with a discount rate, the capital budgeting analysis can now begin. The project has an initial cost of $192 million. Of this, $180 million is in assets that will be depreciated. The depreciation schedule for MACRS according to the IRS is attached as Table 1-A at the end of this work. The effective tax rate for Amazon, based on 2012 income has been quite variable in the past five years. The five-year average tax rate will be used, which is 36.46%,though the 33% given in the case could also be used. While depreciation itself is not a cash flow, it does reduce the company's tax burden, and therefore that reduction should.....

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