¶ … 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...
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