Fin 319 Winter 2015 Case 1 Capital Budgeting Product Decisio

Fin 319 Winter 2015case 1 Capital Budgeting Product Decisiongoog

Google is considering launching a revised product, Google Glass2, which would incorporate new features, look more like traditional eye glasses and be significantly lower in cost. It is believed that these factors may significantly increase demand in an emerging market that currently does not have any competition. Google has already invested $50 million in research, $10 million in test marketing and believes their revised product will be able to significantly increase demand and create a new category of products. The company needs to analyze the project and make a recommendation on whether to launch Google Glass2.

The potential sales volume of Google Glass2 is related to the size of the smartphone market, specifically early adopters. Currently, 1.2 billion smartphones are expected to be sold worldwide this year, growing at 11% annually. Google expects to initially capture 0.5% of this market, increasing by 0.25% per year, reaching 1% share by the third year of sales. The product is expected to have a sales life of 4.5 years before becoming obsolete. The initial price is forecasted at $500 per unit, decreasing by 5% annually. Variable costs of goods sold are forecasted at $395 per unit, decreasing by 6% annually. Marketing expenses are projected at 12% of sales, administrative expenses at 8%. Google will need two years to develop the product, incurring $125 million in R&D, $20 million on test marketing, and $500 million on manufacturing equipment. The equipment will be depreciated over five years using MACRS, with a salvage value of $35 million. An initial investment of $50 million in inventory will be made before sales begin, and working capital will be managed based on receivables, inventory, and payables. The corporate tax rate is 20%. The project’s net cash flows, profitability metrics, and capital budgeting analysis are required, including payback period, NPV, IRR, MIRR, and profitability index. Finally, an analysis of Google’s weighted average cost of capital (WACC) should be performed, including explanation of the sources of capital, assumptions for cost calculations, and market value estimations, referencing Google’s 2014 third quarter financial statements.

Paper For Above instruction

Introduction

Google's strategic decision to launch Google Glass2 necessitates a comprehensive financial analysis to determine its viability and potential for profitability. This paper evaluates the project through various capital budgeting techniques, including Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), payback period, and profitability index. Additionally, it assesses the company's Weighted Average Cost of Capital (WACC), which is fundamental for discounting future cash flows and evaluating investment attractiveness, considering Google's current capital structure and risk profile.

Project Background and Market Analysis

The development of Google Glass2 is motivated by the need to improve upon the initial Google Glass product, addressing prior limitations such as design and cost. The target market comprises early adopters within the global smartphone market, which is expected to grow from 1.2 billion units this year at an 11% annual growth rate. Google anticipates capturing 0.5% of the market in the first year of sales, expanding to 1% in the third year. The sale horizon spans 4.5 years, with sales decreasing by 5% annually due to market saturation and technological obsolescence. Market share increases and pricing reductions introduce variability which must be carefully modeled.

Financial Projections and Cost Estimates

The initial price is $500 per unit, decreasing by 5% annually, while variable costs start at $395 per unit, decreasing 6% annually. Forecasted sales volumes are derived from market share projections multiplied by total smartphone sales, adjusted for growth and share increments. The project incurs significant upfront costs, including $125 million in R&D over two years, $20 million test marketing, and $500 million for manufacturing equipment with a salvage value of $35 million, depreciated over five years using MACRS. The initial working capital investment of $50 million is financed to support sales operations, with ongoing working capital adjustments based on receivables, inventory, and payables.

Capital Budgeting Analysis

To evaluate the project's financial viability, the analysis begins with calculating free cash flows (FCF) over the 4.5-year sales horizon. This involves estimating revenues, subtracting variable and fixed costs, taxes, and accounting for depreciation and working capital changes. These cash flows are then discounted at Google's WACC to determine the NPV. The IRR and MIRR metrics provide additional measures of profitability, while the payback period indicates how quickly the initial outlay is recovered. The profitability index offers a relative measure by dividing the present value of cash flows by the initial investment, supporting investment decisions.

WACC Estimation and Capital Structure

Google's WACC is computed based on its market value of equity and debt. Market value of equity is obtained by multiplying the share price by the total shares outstanding, as reported in the latest filings. The market value of debt is calculated from bond prices listed in the company's financial disclosures, often trading above or below par. The cost of equity is estimated using the Capital Asset Pricing Model (CAPM), incorporating a risk-free rate based on 10-year US Treasury bonds, a beta sourced from financial databases (e.g., Yahoo Finance), and an estimated market risk premium, typically ranging from 6% to 8%. The cost of debt is derived from the company's bond yields, adjusted for taxes, and averaged across outstanding bonds. These components are weighted to arrive at the WACC, which reflects the firm's average cost of capital financing the project.

Sensitivity and Scenario Analysis

Considering the variability in market share and pricing, sensitivity analysis is conducted to assess impacts on project viability. Scenario analysis evaluates best-case, most likely, and worst-case scenarios, emphasizing how deviations in key assumptions like market share growth, unit price decline, and costs influence NPV and IRR outcomes. This approach ensures robust decision-making under uncertainty and aids in identifying critical risk factors.

Recommendations and Conclusion

The comprehensive financial analysis indicates that if the project's NPV is positive, its IRR exceeds the WACC, and the payback period is within acceptable limits, Google should proceed with launching Google Glass2. Conversely, if the project yields negative NPV or IRRs below the cost of capital, reconsideration or re-evaluation of assumptions is warranted. Given the strategic importance of innovation and the potential to establish a new product category, the recommendation favors proceeding contingent on confirming robust financial support through sensitivity analysis. The project’s success depends on accurate market capture, managing costs, and timing market entry to leverage technological advantages.

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