Finace case help for brain girl only

Date of Submission: 2/12/2015

Executive Summary

Google Inc is planning to launch a revised product in response to the low sales of Google Glass2. Google glass2 are smart – phone gadgets that display information in a hands free format and enable users communicate with the device via voice command. The company has already done some preliminary research on the needs of customers and probable sales over the time and determined that low cost production techniques will be available. While Google has already been using the Google glass technology for the product for some time, the sales have been below expectations. For this reason, the firm is seeking to reinvent itself and introduce a better product with superior features: Google Glass2. This paper seeks to carry out different analysis to establish whether the product will be viable according to the projections based on the current debt, equity and sales figures. The product will have a 4.5 years life before being renovated or abandoned depending on the outcomes of the projections.

Free Cash Flow Forecast

Google glass2 units will depend on the total number of smartphones and will be launched 2 years from the current year. In the first year of sale, the number of units will be 0.5% of total smartphone market and will later increase by 0.25% per annum. The initial selling price of the product will be $500 and will decrease at a rate of 5% per year, with the variable cost being $395 in the first year before decreasing by 6% in the subsequent years. The company will also incur cash expenses of marketing, and general and administrative expenses in addition to the non- cash expense of depreciation. Before the launch of the product, the company will also have to incur costs in research and development, test marketing, equipment and investment in working capital. The cost of the equipment will be depreciated based on 5 year MACRS and provided as depreciation expense for the year.

Weighted Average Cost of Capital (WACC)

The WACC is the weighted expected return from each components of finance in the capital structure of an organization (Brealey, Myers, & Allen, 2011). Google Inc has both equity and debt components in its capital structure. The WACC will therefore be the weights of respective equity and debt components and this will be used for discounting or accumulation of the cash flows for investment decisions.

Market Weights of Equity and Debt Components

The market value of a company’s stock is a function of stock price at given time and the number of shares in the company. Googles Inc has 678277 shares divided into various classes and the current market price of a stock of the company is $539 (Google Inc, 2014). Therefore, the market value of equity is $365,591,303. Google Inc also has three outstanding corporate bonds with different maturity dates and different prices. The market price of corporate bonds can be determined as number of bonds multiplied by the current market price of the bond (Berk & Demarzo, 2013).

Therefore, the market weights of equity components can be determined as

Cost of Equity

The cost of stock equity is the required rate of return that is attributable to the common stock investors in the company (Brealey, Myers, & Allen, 2011). It can be determined by the use of CAPM model. CAPM model requires the cost of equity be determined as

Rs = Rf +b (Rm –Rf)

Where; Rf – Risk free rate; b – beta; Rm –Market return

The risk free rate is the rate of return on default free securities such as Treasury bill and bonds. Google glass2 has an average life of 4.5 years and being that the risk free rate should be equal to the life of the project; the best estimate of risk free rate is a 5-year US Treasury bond, which averaged 1.32% in 2014.The beta of Google Inc, has been estimated to be 1.16.The market return is 10.86%. The market return of used to estimate market return is the NASDAQ100 index for one year ending September 2014.

The CAPM can then by calculated as

1.32% + 1.16(10.86% - 1.32%) = 11.066%

Cost of debt

The cost of debt is coupon rate of the bond. Google Inc has three different bonds with different coupon rates (Google Inc, 2014)The weighted average cost of debt is

The after tax cost of debt involves adjusting pre –tax cost of debt to the tax deductibility of interest thus calculated as Rd (1- T)

6.08% * (1-0.2%) = 4.87%.

The WACC of the company can therefore calculated as

WACC = WsRs + WdRd(1-T)

Capital Budgeting Technique Analysis and Recommendation

Net Present Value (NPV)

The NPV of a project is the present value of future free cash flows less the cost incurred in the initial outlay (Berk & Demarzo, 2013). A project analyzed using the NPV technique should be approved if the NPV is positive and rejected if the NPV is negative. Based on the analysis in appendix 2, the NPV of the Google2 is -$28.503m. With a negative NPV the project will be rejected since it does not add value to the shareholders of the company.

The calculation of the NPV has been based on the assumptions. First, the useful life of the product is 4 years. In the calculation of the NPV, five years have been used. If the last year was to be divided into two halves and the cash flows from the last half deducted, the NPV would still be negative. Secondly, there are a number of costs which have been incurred before launching the product. Some of the costs such as research and development are incurred two years before launching of the product. Accumulation of the R&D costs gives a total of $129.09m which is included in the cost of initial outlay. Google can do a number of things to ensure that the NPV of the product is positive and thus the project accepted. The WACC is based on the CAPM and cost of debt. Reducing its cost of equity and debts would reduce the rate at which the cash flows are discounted and this would slightly increase the PVs of cash flows. Effective absorption of some of the costs incurred before launch of the product could also reduce the initial outlay (expenses) and thus boost the NPV value.

Internal Rate of Return (IRR)

The IRR of a project is the rate of return that equates the present value of free cash flows to the initial cash outflow (Ehrhardt & Brigham, 2011). The decision criterion for this technique is to accept the project if the IRR is greater than zero since the project will have break evened. The IRR of the Google2 has been calculated through the extrapolation of NPVs at different interest rates. At 8.18%, the NPV is -28.503m. At 5%, the NPV is $49.5222m. Through the extrapolation, the IRR is found to be 6.89%. Based on this IRR, the Google Glass2 product should be accepted since the costs have break evened. In addition, the IRR (6.89%) is relatively higher than zero, and this means that the project will produce some returns. Reduction of some of the initial outlay expenses (those that can be avoided) is a sure way of boosting the IRR. In addition, Google ought to work towards the reduction of the cost of capital such that the cash flows are discounted at a lower rate of interest.

Profitability Index (PI)

The PI of a project is the present value of a project’s future cash flows divided by the initial cash outflow. The decision criteria is to accept the project if the profitability index is greater than 1 or 100% (Berk & Demarzo, 2013). The FV of the future cash flows is $640.587m while the initial outlay is $669.09. Google has a PI of 95.74% (640.587/669.09). Since the PI is less than 100%, Google should reject the Google2 project since it will not be profitable to the firm.

Modified Internal Rate of Return (IRR)

Modified IRR is a project appraisal technique that seeks to equate the terminal value of a project with its initial cash outlay (Berk & Demarzo, 2013). The terminal value of a project is based on the assumption that cash flows are reinvested at the WACC. The MIRR of the Google2 will be:

= (n) sqrt (FV of Cash flows/Initial Outlays) – 1

FV of cash flows = 42.6* 1.0818^4 + 99.26 * 1.0818^3 +128.55 * 1.0818^2 + 186.6 * 1.0818^1 + 412.73 = 949.04424

Initial Outlay = 669.09

So MIRR = {(949.04424/669.09)}^ 1/5 – 1 = 0.0724. So the MIRR will be 7.24%

The decision criteria is to accept the project if the MIRR is larger than the WACC. Projects are rejected if the MIRR is less than the WACC. In this case, the rate of reinvestments of the cash flows is lower than the rate at which the cash flows are being discounted. For this reason, the Google2 ought to be rejected.

Payback Period

This is the length of time it takes for a firm to recover all the costs incurred in investments. Payback period is a determinant of whether an organization will accept or reject the project under consideration (Ehrhardt & Brigham, 2011). Google has 4.5 years to make sales from the Google Glass2 and thus a payback period of more than 4.5 years will not be accepted. The payback period should be less than 4.5 years.

The payback period is:

4 years + 212.08/412.73 = 4.5138 years.

Since the payback period does not take into account the time value of money, the real cash flows are used. Google Glass2 will take a period of 4.5138 years to recover the initial costs invested. This is more than the economic life of the product. Based on the payback period method, Google should not accept the Google2 product since all the costs invested in the product will not be recouped within its economic lifetime.

Synthesis and Recommendations

A number of approaches have been used in assessing the feasibility of the Google Glass2 project. Based on the evidence from the projections and the cash flows over the useful life of 4.5 years, Google Glass2 should be rejected. The NPV approach takes into consideration the cash flows from the project and for this reason incorporates the risk element. Since the Glass2 project has a negative NPV, rejecting will the option since it will not add value to the portfolio owned by the Google shareholders. Profitability element should also be a part of the feasibility tests. Glass2 project fails to reach the threshold of 1 so as to guarantee acceptance. This means that the project will not be profitable to Google if accepted. Although IRR approach hints at the project acceptance, a more robust approach put forward by MIRR gives further rejection evidence. MIRR is a more realistic approach in assessing performance of project. Since MIRR is less than the WACC, the reinvestment rate is lower and therefore Google Glass2 ought to be rejected.

References

Berk, J., & Demarzo, P. (2013). Corporate Finance (3edn ed.). Boston: Pearson Education Inc. Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of Corporate Finance (10th ed.). New York: McGraw -Hill Irwin. Ehrhardt, M. C., & Brigham, E. F. (2011). Finance Management Theory and Practice (13edn ed.). Mason: South Western Cengage Learning. Google Inc. (2014). Finance. New York: Yahoo Finance . Google Inc. (2014). Financial Markets. New York: Morning Star. Google Inc. (2014). Google Earnings. New York: Google Finance .

Appendix

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Net Present Value