com Inc is an Americanelectronic commerce and cloud computing company based in the Seattle,Washington, founded by Jeff Bezos in 1994. Since then Amazon has grown into ahousehold name and the largest internet retailer in the world when measured byrevenue and market capitalisation. Through the years Amazon has diversifiedfrom the online bookstore it started as, expanding its operations to sell anumber of diversified products. Furthermore, the company also produces consumerelectronics with the Kindle e-reader being at the forefront. Last year, Amazonpurchased Whole Foods Market, which brought many to argue that in doing so theyare directly competing with Walmart by increasing their physical retailpresence.
The report will seek to establishtwo main tasks, identifying the Cost of Equity and the Weighted Average Cost ofCapital (WACC). In doing so the 2016 Annual Report for Amazon will be utilised. 2. Question 1: Cost of EquityIn corporate finance the Cost ofEquity refers to the rate of return a company should pay to its shareholders. Inother words, it is the rate a company should use to convince an investor tomake an equity investment. However the way the cost of equity is explained dependson the interest of the party involved. From an investor’s point of view thecost of equity refers to the required rate of return on an investment inequity.
On the other hand, if you are representing the company, the cost ofequity refers to the required rate of return on a particular project. A company’s capital is made up ofdebt or equity or often a combination of both. Debt is normally cheaper thanequity however will needs to be repaid. Equity costs more than debt howeverdoes not need to be repaid and provides a higher rate of return. The cost of equity may be determined througheither the Dividend Growth Model or the Capital Asset Pricing Model (CAPM). In order to use the DividendGrowth Model to calculate equity, the company must pay dividends, which createsa limitation in its use.
This model is based upon the cost for a company to payits shareholders dividends which would reflect the company’s cost of equity. TheCAPM model can be used in relation to companies who do not pay dividends, andis based on the theory that the stock’s unpredictability and the level of riskin comparison to the general market affect the cost of equity.The below represents the workingof the cost of equity for Amazon using the CAPM model, which was used sinceAmazon does not pay dividends. Ke = Rf + (Rm-Rf) The CAPM formula is made up ofthe risk free rate (Rf), which is the rate of return paid on low riskinvestments (e.g.
Government Stock) (obtained from the 10-Year TreasuryConstant Maturity Rate as at December 2016 – 2.49%). Beta (is a way of measuring riskbased on volatility, high volatility meaning high risk, thus a higher betameans higher profits as well as higher risks (obtained from Yahoo Finance forAmazon.com Inc – 1.39) and the average market rate (Rm-Rf), (obtained from themarket risk premium used for 71 countries in 2016) this figure represents theaverage interest rate an investor would make by investing in the US stockmarket.
Ke = Rf + ((Rm-Rf))= 2.49% + (1.39(5.3%))= 1.39 x 5.3%= 7.
367%= 2.49% + 7.367%Ke = 9.86% Therefore 9.
86% is the percentagereturn one should expect to make the investment worthwhile if investing inAmazon.com Inc. 3. Question 2 (a): Weighted Average Cost of Capital (WACC)The WACC is used to determine the cost of capital. Capitalis made up from either debt or equity or a combination of both. If thecompany’s capital comes from debt, then the cost of capital is the bank’sinterest rate percentage charged to the company. Whereas, if the company’scapital is made up from equity, then the cost of capital is the cost of equityor expected percentage return to its investors.
However most company’s capitalis made up from both debt and capital, and the WACC is used to help usdetermine the cost of capital in such scenarios. The below is the formula usedin this report to calculate the WACC for Amazon.com Inc.
WACC = E/(E+D) x Cost of Equity +D/(E+D) x Cost of Debt x (1- Tax Rate) In order to be able to work out the above formula, anumber of steps/workings need to be carried out before. Firstly we need tocalculate the cost of debt. This is done by using the information from thebalance sheet and income statement for Amazon.com Inc ending 31st December2016. Calculating the Cost of DebtAllnumbers in thousands 2016 $ 2015 $ Current maturity of long term debt – – Long term debt 7,694,000.00 8,227,000.
00 Total debt 7,694,000.00 8,227,000.00 Interest paid 484,000.00 – Average Interest rate 484,000/((7,694,000+8,227,000)/2)*100 = 6.08% Calculating the Tax rate 2016 Income before taxes 3,892,000.00 Income tax expense 1,425,000.
00 Tax rate (T) (1,425,000.00/3,892,000.00)*100 = 37% Calculating the WACC % Cost of Equity (calculated using the CAPM model above) 9.86% % Cost of Debt (calculated in step 1 above) 6.
08% # of shares outstanding (obtained from statistics information on yahoo finance) 481,870 Current share price (05/01/2018) $1,229.14 Market value of Equity (E) =481,870 * 1,229.14 592,285,691.
80 Value of Debt (D) 7,694,000.00 Total Equity + Debt (E+D) 599,979,691.80 % of Equity =(592,285,691.80/599,979,691.80)*100 = 98.72% % of Debt =(7,694,000/599,979,691.80)*100 = 1.
28% Tax rate (T) 37% Therefore the WACC formula above may be written as:WACC = 0.987 x 9.86 + 0.013 x 6.
08x (1- 37)= 9.732 + (0.079 x 0.630)= 9.
732 + 0.050= 9.78%Therefore a WACC of 9.78% for Amazon means that it mustpay its investors an average of $0.
098 for every $1 in extra funding. Question 2 (b): Practical problems/difficulties encounteredin calculating the WACC for AmazonAs explained above, the WACC is used to determine the costfor a company to acquire capital through a combination of equity and debt. Theanswer will provide the discount rate which will help in determining thepresent value of a company’s cash flow.
However, any variations in the WACC mayhave varying implications on the decision makers within any company. In order to calculate the WACC, one must first work outthe cost of equity. Whether using the CAPM model or the dividend discountmodel, the recurring problem is that at least one of the variables will be anestimate. For example, in calculating the cost of equity using the CAPM modelfor Amazon an assumption is being made about the market risk premium sincehistorical data was used. Due to the variationsof estimates being used the resultant cost of equity may vary, thus havingimplications on calculating WACC. Further assumptions are made in determining the cost ofdebt, which is required to calculate the WACC.
The total debt may be calculatedby adding the short term debt and the long term debt, as indicated in thebalance sheet. The data provided in the balance sheet for Amazon (as at31/12/2016) did not include any entry for short/current long term debt, howeverincluded an entry for current liabilities. In working the cost of debt for thisreport, an assumption was made that the current liabilities did not include anyshort term debt and thus only the entry for long term debt was taken intoconsideration for this report.
Due to such assumptions, it is difficult for any twoanalysts to come to the same result, and therefore may be argued that the WACCmay be inaccurate. 4. Question 3 (a): Foreign Exchange RiskTransactionRiskWhen considering Amazon’s business process structure, with an orderingprocess consisting of lead times, transaction delays and delivery setbacks, anyfluctuations in the rate of exchange may lead to a change in the income for thecompany. An order made today may take a while to be processed and delivered soin light of that, the value of the price paid is not necessarily the same valueof the income received. This may have a weighting on people’s decisions to buyor sell their stock depending on the way the rate of exchange is affecting therevenues of the company. The foreign exchange transaction risk to a share’s value is dependent onthe business process through the passage of time and considers the public’sperception over the change that presents itself, be it great or small. EconomicRiskThere are a number of factors that may pose an economic risk to the valueof a share, not least of which the rate of exchange. Maybe less directly thanother risks, a difference in the exchange rate may affect sales which affectsthe bottom line which affects public interest which subsequently affects shareprice.
Fluctuations in the price of a foreign currency may have an effect on theprice of imported products in the country, resulting in a drop in the generaldemand for one product that’s imported over a similar alternative productthat’s domestic. A drop in sales of a foreign company due to an unfavourableexchange rate, which seems to be happening more and more since the dawn ofonline shopping, is noted by the market and is reflected in share price,understandably somebody would not want to invest in a company with dwindlingsales resulting in a drop in public interest. TranslationRiskDue to technological developments, the means of reporting andtransferring information have accelerated considerably, at par with that though,transactions and trading have also accelerated. This, although not directlyaffecting a company’s cash flow may have a significant impact on a firm’sreported earnings resulting in a significant impact on share price. Bull and bear markets are created by publicperception and are dependent on how traders perceive the value pertaining toequity, value would be viewed differently if the bottom line on the financialstatements is seen to have increased or decreased due to any fluctuations inthe value of a currency. Amazon shares are traded in dollars however, arebought by traders the world over, hence investing other currencies, the same istrue for the reported financials. Public opinion and desire to purchase equitywill be affected once the rates of exchange start to cast a dark shadow overthe perceived value of a company.
Question 3(b): Four main internal hedgingstrategiesThere are a number of strategies that a company mayutilise in order to minimise the risk coming from foreign exchange. The methodsmay be divided into two seperate groups, internal and external hedgingstrategies. The below identifies four main internal heding strategies that maybe used to reduce foreign exchange risk. HomeCurrency InvoicingHome Currency Invoicing means that a transaction iscarried out in the home currency of the exporter, so as to minimise uncertaintyof the transaction. In this way the risk is transferred onto the customer. Acompany such as Amazon, is in a better position to use such a strategy due toits strong presence on the market which gives it better bargaining power inusing this strategy.
CurrencyNettingCurrency netting refers to the offsetting of receivablesin a particular foreign currency with the payables due in that same foreign currency.This strategy limits the foreign exchange risk only on the net amount. A company such as Amazon that is constantlydealing with different currencies, is constantly exposed to such exchangerisks, therefore this strategy may be beneficial for Amazon in minimising suchrisks. It is however important to note a number of factors that come to playfor this strategy to help minimise risk, such as the timing of paymentsvis-a-vis receivables and the amount involved. CurrencyLoanThis strategy is often used by companies who have a goodproportion of customers being invoiced in the same currency. Due to the hugeadministrative burden this would cause a company, the company would group allsuch customers together and taking an overdraft facility in the respectiveforeign currency, thus securing the amount the amount which will be received.Once the individual payments start coming in, they will be used to pay off theoverdraft.
Leadingand LaggingNo matter how smallor large a company may be, it will always push for earlier payments from itscustomers, referred to as leading, and for later payments to its suppliersreferred to as lagging. This is even more so done when there is suspicion thatthere may be movements within the specific foreign exchange currency, tominimise foreign exchange risk. Amazon may decide to delay or hastily concludepayments or receipts within its own subsidiaries is due to taxation.
It ishowever important to note that the forecasted movement may not go as expectedand may have adverse implications on the planned strategy. Even though Amazonhas separate retail websites for a number of countries across the world, mosttransactions are made with hard and stable currencies such as the US dollar,which normally do not experience major fluctuations.