8.23  Residual Operating Income (ReOI)

This income number is defined as:

ReOI = NOPAT_t – (Weighted Average Cost of Capital * Net Operating Assets_t-1 )

The weighted average cost of capital was defined in chapter 4.  A brief description is provided below:  The cost of equity capital for the firm as a whole is different from the cost of equity capital for the stock issued by the firm, and the usual formulation is in terms of the after tax weighted average cost of capital.

Where τ_c is the effective corporate tax rate, k_d is the cost of debt capital and k_e is the cost of equity capital.  The weights are usually constructed relative to market values.  The above equation works with the after tax cost of debt because interest expense is tax deductible whereas dividend payments are not.  

Net Operating Assets (NOA) is defined as total assets minus operating liabilities for a segment.

NOA = Total Assets − Operating Liabilities

Operating Liabilities are usually defined in terms of working capital liabilities such as Accounts Payables, Income Taxes Payable, Other Current Liabilities, Other Liabilities, Minority Interest.  That is, liabilities that do not involve the financing decision.  The remaining liabilities and preferred stock if issued, are referred to as Net Financial Obligations (NFO) and:

Shareholders’ Equity = NOA - NFO

A closer inspection of the consolidated balance sheet reveals that: 

  

So as a first pass computing for t-1 (= 2008)  NOA is:

NOA = 8,314 – 4,746 – 487 = 3,081

Now calculate ReOI as:

ReOI = NOPAT_t – (Cost of Equity Capital * Net Operating Assets_t-1 )

We will allocate 3,081 on the basis of relative proportion of total assets (e.g., North America = 5266/8314 = 0.633).

We will assume that the required rate of return for Amazon which equals the WACC (weighted average cost of capital) is provided by CAPM = 0.0406 + 1.21*0.051 = .1023 because Amazon has very little outstanding debt especially when we define the weights by relative market values of stock and bonds.  If you refer to the WACC equation provided earlier you will see that the debt weighting is Market Value of Debt/(Market Value of Debt plus Equity).

The above inputs for CAPM you can get immediately from Valuation Tutor by clicking on the relevant parts (e.g., beta from Profile and either Beta (MSN) or Beta (Yahoo), Bonds MSN to get the 30-year bond rate, and finally “Equity Premium Surver” to get the current consensus (0.051)).

 

North America = 510.13 – 3081*(5266/8314)*0.1023 =310.49

International = 620.94 - 3081*(1-(5266/8314))*0.1023 = 505.39

From the first pass it appears that International performs better than North America.  This may reflect that they have less competition internationally or it may also reflect the breakdown of total assets and especially leased facilities.  It is likely that leased facilities are more prevalent in the international operations and thus accounting for leases (i.e., operating versus capitalized) should be considered.  Amazon does not break this out by segment in their 10-K aand they discuss leases as follows:

Leases and Asset Retirement Obligations

We categorize leases at their inception as either operating or capital leases. On certain of our lease agreements, we may receive rent holidays and other incentives. We recognize lease costs on a straight-line basis without regard to deferred payment terms, such as rent holidays that defer the commencement date of required payments. Additionally, incentives we receive are treated as a reduction of our costs over the term of the agreement. Leasehold improvements are capitalized at cost and amortized over the lesser of their expected useful life or the life of the lease, excluding renewal periods. We establish assets and liabilities for the estimated construction costs incurred under build-to-suit lease arrangements to the extent we are involved in the construction of structural improvements or take some level of construction risk prior to commencement of a lease.

But note Amazon has been careful to separate out the two segments in terms of capacity:

International

The International segment consists of amounts earned from retail sales of consumer products (including from sellers) and subscriptions through internationally focused websites such as www.amazon.co.uk, www.amazon.de, www.amazon.co.jp, www.amazon.fr, and www.amazon.cn. This segment includes export sales from these internationally based sites (including export sales from these sites to customers in the U.S. and Canada), but excludes export sales from www.amazon.com and www.amazon.ca.

So it would appear that currently International earns a little more margin.