Question

Explain the current capital structure of Amazon and recommendations to optimize capital structure. Include cost of debt and equity (e.g. interest rates, preferred dividends, other required annual cash payments from financing).

Answer 1

The Basics of Optimal Capital Structure

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

Key Takeaways

• An optimal capital structure is the objectively best mix of debt, preferred stock, and common stock that maximizes a company’s market value while minimizing its cost of capital.
• Weighted average cost of capital (WACC) is one way to optimize for the lowest cost mix of financing. However, WACC does not account for credit risk, taxes, and asymmetric information.
• According to economists Modigliani and Miller, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information; and in an efficient market, the value of a firm is unaffected by its capital structure. We know that in reality firms do face these obstacles.

Changes in Capital Structure Send Signals to the Market

As it can be difficult to pinpoint the optimal structure, managers usually attempt to operate within a range of values. They also have to take into account the signals their financing decisions send to the market. A company with good prospects will try to raise capital using debt rather than equity, to avoid dilution and sending any negative signals to the market. Announcements made about a company taking debt are typically seen as positive news – which is known as debt signaling. If a company raises too much capital during a given time period, the costs of debt, preferred stock, and common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The default spread attached to the bond rating can then be used for the spread above the risk-free rate of an AAA-rated company.