1. in comparison to the general market affect the

1. Introduction

Amazon.com Inc is an American
electronic commerce and cloud computing company based in the Seattle,
Washington, founded by Jeff Bezos in 1994. Since then Amazon has grown into a
household name and the largest internet retailer in the world when measured by
revenue and market capitalisation. Through the years Amazon has diversified
from the online bookstore it started as, expanding its operations to sell a
number of diversified products. Furthermore, the company also produces consumer
electronics with the Kindle e-reader being at the forefront. Last year, Amazon
purchased Whole Foods Market, which brought many to argue that in doing so they
are directly competing with Walmart by increasing their physical retail
presence.

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The report will seek to establish
two main tasks, identifying the Cost of Equity and the Weighted Average Cost of
Capital (WACC). In doing so the 2016 Annual Report for Amazon will be utilised.

 

2. Question 1: Cost of Equity

In corporate finance the Cost of
Equity refers to the rate of return a company should pay to its shareholders. In
other words, it is the rate a company should use to convince an investor to
make an equity investment. However the way the cost of equity is explained depends
on the interest of the party involved. From an investor’s point of view the
cost of equity refers to the required rate of return on an investment in
equity. On the other hand, if you are representing the company, the cost of
equity refers to the required rate of return on a particular project.

A company’s capital is made up of
debt or equity or often a combination of both. Debt is normally cheaper than
equity however will needs to be repaid. Equity costs more than debt however
does not need to be repaid and provides a higher rate of return.  The cost of equity may be determined through
either the Dividend Growth Model or the Capital Asset Pricing Model (CAPM).

In order to use the Dividend
Growth Model to calculate equity, the company must pay dividends, which creates
a limitation in its use. This model is based upon the cost for a company to pay
its shareholders dividends which would reflect the company’s cost of equity. The
CAPM model can be used in relation to companies who do not pay dividends, and
is based on the theory that the stock’s unpredictability and the level of risk
in comparison to the general market affect the cost of equity.

The below represents the working
of the cost of equity for Amazon using the CAPM model, which was used since
Amazon does not pay dividends.  

 

Ke =  Rf + (Rm-Rf)

 

The CAPM formula is made up of
the risk free rate (Rf), which is the rate of return paid on low risk
investments (e.g. Government Stock) (obtained from the 10-Year Treasury
Constant Maturity Rate as at December 2016 – 2.49%).

 

 

 

Beta (is a way of measuring risk
based on volatility, high volatility meaning high risk, thus a higher beta
means higher profits as well as higher risks (obtained from Yahoo Finance for
Amazon.com Inc – 1.39) and the average market rate (Rm-Rf), (obtained from the
market risk premium used for 71 countries in 2016) this figure represents the
average interest rate an investor would make by investing in the US stock
market.

 

 

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 percentage
return one should expect to make the investment worthwhile if investing in
Amazon.com Inc.

 

3. Question 2 (a): Weighted Average Cost of Capital (WACC)

The WACC is used to determine the cost of capital. Capital
is made up from either debt or equity or a combination of both. If the
company’s capital comes from debt, then the cost of capital is the bank’s
interest rate percentage charged to the company. Whereas, if the company’s
capital is made up from equity, then the cost of capital is the cost of equity
or expected percentage return to its investors. However most company’s capital
is made up from both debt and capital, and the WACC is used to help us
determine the cost of capital in such scenarios. The below is the formula used
in 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, a
number of steps/workings need to be carried out before. Firstly we need to
calculate the cost of debt. This is done by using the information from the
balance sheet and income statement for Amazon.com Inc ending 31st December
2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

Calculating the Cost of Debt

All
numbers 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 6.08
x (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 must
pay its investors an average of $0.098 for every $1 in extra funding.

 

Question 2 (b): Practical problems/difficulties encountered
in calculating the WACC for Amazon

As explained above, the WACC is used to determine the cost
for a company to acquire capital through a combination of equity and debt. The
answer will provide the discount rate which will help in determining the
present value of a company’s cash flow. However, any variations in the WACC may
have varying implications on the decision makers within any company.

In order to calculate the WACC, one must first work out
the cost of equity. Whether using the CAPM model or the dividend discount
model, the recurring problem is that at least one of the variables will be an
estimate. For example, in calculating the cost of equity using the CAPM model
for Amazon an assumption is being made about the market risk premium since
historical data was used.  Due to the variations
of estimates being used the resultant cost of equity may vary, thus having
implications on calculating WACC.

Further assumptions are made in determining the cost of
debt, which is required to calculate the WACC. The total debt may be calculated
by adding the short term debt and the long term debt, as indicated in the
balance sheet. The data provided in the balance sheet for Amazon (as at
31/12/2016) did not include any entry for short/current long term debt, however
included an entry for current liabilities. In working the cost of debt for this
report, an assumption was made that the current liabilities did not include any
short term debt and thus only the entry for long term debt was taken into
consideration for this report.

Due to such assumptions, it is difficult for any two
analysts to come to the same result, and therefore may be argued that the WACC
may be inaccurate.

 

4. Question 3 (a): Foreign Exchange Risk

Transaction
Risk

When considering Amazon’s business process structure, with an ordering
process consisting of lead times, transaction delays and delivery setbacks, any
fluctuations in the rate of exchange may lead to a change in the income for the
company. An order made today may take a while to be processed and delivered so
in light of that, the value of the price paid is not necessarily the same value
of the income received. This may have a weighting on people’s decisions to buy
or sell their stock depending on the way the rate of exchange is affecting the
revenues of the company.

The foreign exchange transaction risk to a share’s value is dependent on
the business process through the passage of time and considers the public’s
perception over the change that presents itself, be it great or small.

 

Economic
Risk

There are a number of factors that may pose an economic risk to the value
of a share, not least of which the rate of exchange. Maybe less directly than
other risks, a difference in the exchange rate may affect sales which affects
the bottom line which affects public interest which subsequently affects share
price.

Fluctuations in the price of a foreign currency may have an effect on the
price of imported products in the country, resulting in a drop in the general
demand for one product that’s imported over a similar alternative product
that’s domestic. A drop in sales of a foreign company due to an unfavourable
exchange rate, which seems to be happening more and more since the dawn of
online shopping, is noted by the market and is reflected in share price,
understandably somebody would not want to invest in a company with dwindling
sales resulting in a drop in public interest.

 

Translation
Risk

Due to technological developments, the means of reporting and
transferring information have accelerated considerably, at par with that though,
transactions and trading have also accelerated. This, although not directly
affecting a company’s cash flow may have a significant impact on a firm’s
reported earnings resulting in a significant impact on share price.

Bull and bear markets are created by public
perception and are dependent on how traders perceive the value pertaining to
equity, value would be viewed differently if the bottom line on the financial
statements is seen to have increased or decreased due to any fluctuations in
the value of a currency. Amazon shares are traded in dollars however, are
bought by traders the world over, hence investing other currencies, the same is
true for the reported financials. Public opinion and desire to purchase equity
will be affected once the rates of exchange start to cast a dark shadow over
the perceived value of a company.

 

Question 3(b): Four main internal hedging
strategies

There are a number of strategies that a company may
utilise in order to minimise the risk coming from foreign exchange. The methods
may be divided into two seperate groups, internal and external hedging
strategies. The below identifies four main internal heding strategies that may
be used to reduce foreign exchange risk.

 

 

 

 

 

Home
Currency Invoicing

Home Currency Invoicing means that a transaction is
carried out in the home currency of the exporter, so as to minimise uncertainty
of the transaction. In this way the risk is transferred onto the customer. A
company such as Amazon, is in a better position to use such a strategy due to
its strong presence on the market which gives it better bargaining power in
using this strategy. 

 

Currency
Netting

Currency netting refers to the offsetting of receivables
in 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 constantly
dealing with different currencies, is constantly exposed to such exchange
risks, therefore this strategy may be beneficial for Amazon in minimising such
risks. It is however important to note a number of factors that come to play
for this strategy to help minimise risk, such as the timing of payments
vis-a-vis receivables and the amount involved.

 

Currency
Loan

This strategy is often used by companies who have a good
proportion of customers being invoiced in the same currency. Due to the huge
administrative burden this would cause a company, the company would group all
such customers together and taking an overdraft facility in the respective
foreign 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 the
overdraft.

 

Leading
and Lagging

No matter how small
or large a company may be, it will always push for earlier payments from its
customers, referred to as leading, and for later payments to its suppliers
referred to as lagging. This is even more so done when there is suspicion that
there may be movements within the specific foreign exchange currency, to
minimise foreign exchange risk. Amazon may decide to delay or hastily conclude
payments or receipts within its own subsidiaries is due to taxation. It is
however important to note that the forecasted movement may not go as expected
and may have adverse implications on the planned strategy. Even though Amazon
has separate retail websites for a number of countries across the world, most
transactions are made with hard and stable currencies such as the US dollar,
which normally do not experience major fluctuations.