Managerial Finance

The aim is to find the capital preferences of the corporations and offer effective recommendations. The report uses such methods of analysis as WACC estimation and EVA calculation. The analysis relies on financial topics, namely cost of capital and capital budgeting. Key financial terms are weighted average cost of capital (WACC) and economic value added (EVA). Appendices include all financial data for the enterprise. The paper argues that Alphabet has a strong financial position with high revenues and operating income. In addition, the firm has strong financial solvency, as it relies mainly on shareholders’ equity. Alphabet’s cost of capital is estimated at 9.49%. EVA of the corporation has been trending higher since 2015 to about $18.5 billion in 2017. The report finds that the company has a significant capacity to increase its debt and reduce the overall cost of capital. The growing EVA also suggests that the firm is in a good financial position, so it can be more aggressive in its financing/investment decisions. It is recommended that Alphabet add more debt to its capital in order to benefit from the tax shield and lower the cost of capital as well as apply project ranking by net value added to its investment activity. Nevertheless, the report has some limitations. Firstly, the analysis does not cover comparison of Alphabet and its competitors to determine common trends in the industry. Secondly, the report does not consider current economic conditions that have a substantial impact on the cost of capital and investments. Thirdly, the report does not cover strategic and marketing aspects that are very important for the company.

Managerial Finance

This paper relates to managerial accounting and analyzes financial performance of Alphabet (Google) Incorporation. Capital budgeting and the cost of capital have a strong effect on a firm’s value. The aim of the paper is to identify Alphabet’s preferences in terms of debt and capital as well as to determine the cost of capital. It consists of five sections that flow from company performance evaluation to conclusions and recommendations. The report reveals that the organization relies more on the equity of shareholders to fund its investment activity, and a growing EVA proves that this strategy has been beneficial. However, the analysis shows that Alphabet can benefit from a reduction in its cost of capital by increasing the share of debt in its total capital.

Company Performance

Google has exhibited exemplary financial results in recent years. The tables included in Appendices provide key financial statements for the corporation. As Table 1 demonstrates, Google’s total assets and equity have been growing recently. Table 1 suggests that the company’s performance has been driven largely by the improvement of retained earnings and shareholders’ equity. Table 1 also displays that Google has a great liquidity position since its cash exceeds current liabilities. This fact also indicates that the company has a great financial position. Table 2 provides the income statement for Google Inc. It shows that the organization’s sales have increased sharply in recent three years from $75 billion to $110.855 billion. The firm’s operating costs soared at a lower rate thereby leading to a higher operating margin, which is positive for the organization. Hence, operating income has escalated from $19.36 billion to more than $26 billion (Alphabet, 2017). EBT has increased from $19.65 billion to more than $27 billion over the period as Table 2 demonstrates. However, net income has slumped in 2017 to $12.66 billion from $19.478 billion in 2016 because of higher tax payments (Alphabet, 2017). Table 3 shows the cash flow statement for Google. Thus, the company’s cash flows have grown steadily in recent three years. The spike in cash was attributed to the rise in operating cash flows. As it is seen from Table 3, the operating cash flow of the corporation has increased rapidly over the period. However, the net change in cash has been negative over the period. Therefore, the financial performance of Alphabet can be considered solid with growing revenues and operating profits.

Financial Documents

The report uses major financial statements of the company such as the balance sheet, the income statement and the cash flow statement. Appendices contain Alphabet’s financial statements. They show the change in the firm’s financial performance over the last three years. The data suggests that Alphabet has a strong financial position with constantly improving financial results. The balance sheet describes the capital structure of the corporation along with its major sources and uses of capital. Income statement provides data for financial performance evaluation in recent three years. Finally, the cash flow statement tracks the company’s cash flows and changes in cash value.

Cost of Capital Analysis

Cost of Debt for Google (Alphabet)

The cost of debt depends on a few factors such as duration, credit default risk and liquidity risk (Bodie, Kane, & Marcus, 2013). The bond’s maturity reflects the interest rate exposure. The greater the maturity of the bond the higher the bond cost is. Therefore, this fact reflects the increasing interest rate for longer-term bonds. The second factor relates to the risk of default, as there is a negative relationship between the interest rate and the risk of default of the bond (Bodie et al., 2013). The default risk exposure is measured by the credit rating. The higher the rating of company’s bonds, the lower are its default risk premium and the required rate of return on the bond (Brigham & Ehrhardt, 2017). Nevertheless, Alphabet has the rating of AA+, which is solid (Linnane, 2017). The firm’s most active bonds have the rate of about 2% (Linnane, 2017). Moreover, the cost of debt accounts for 2.76%, according to Gurufocus (2018). It is estimated as the interest expense divided by the book value of debt. The net cost of debt should be adjusted for taxation. Hence, assuming that the tax rate is 25%, Google’s net cost of debt is 2.07%, which is close to the rate on its most active bonds.

Cost of Equity for Alphabet

The cost of equity provides the required rate of return for the company’s stock. Brigham and Ehrhardt (2017) claim that the cost of equity can be calculated using the Capital Asset Pricing Model (CAPM). The model assumes that the firm’s cost of equity is determined by the risk-free rate, the market risk premium and its relative risk as suggested by beta of a stock. As maintained Fernandez, Pershin and Acin (2018), the risk-free rate for the US is 2.8%, while the market risk premium is estimated at 5.4%. According to Yahoo Finance (2018), Alphabet’s beta is 1.33. The stock is considered risky with a beta, which is about 33% higher than the market average. Thus, Google’s cost of equity is calculated as 2.8% + 1.33*5.4% or 9.98%. Therefore, Alphabet’s cost of equity is 9.98%.

Analysis of Capital Budgeting

Capital Structure of Google Inc.

When considering the company’s balance sheet, one can see that the total assets amount to $197.295 billion as of the end of 2017. The firm’s liabilities constitute $44.793 billion while the shareholders’ equity is about $152.5 billion (Alphabet, 2017). In this regard, the book value of equity is $152.5 billion while the book value of debt is almost $44.8 billion. The data suggest that Alphabet’s capital structure is skewed more toward equity. However, the market value of debt and equity is more relevant to the estimation of WACC (Brigham & Ehrhardt, 2017). According to Yahoo Finance (2018), the current market capitalization of Alphabet is $683.94. The market value of debt is close to the book value of total liabilities that is about $44.793 billion. The total capital value of Alphabet is estimated as the sum of the two components, namely $728.733 billion. The share of equity is about 93.85%. Hence, the share of debt is about 6.15%. The market data reveals that the company relies heavily on equity in its capital structure. Chart 1 in Appendices shows Google’s capital structure. Thus, one may conclude that Alphabet depends largely on shareholders and equity, so its WACC is impacted more by the factors that determine the equity prices. In addition, the firm’s cost of capital appears to be higher because of a greater share of shareholders’ equity, which tends to increase WACC since equity is a more expensive source of capital than debt.

WACC Estimation

The analysis suggests that Alphabet has a cost of debt of 2.07% while its cost of equity is 9.98%. The share of debt in total capital is 6.15% and the share of equity is 93.85%. WACC provides the weighted-average measure of cost, so that Google’s cost of capital is about 9.49%. According to Ross, Westerfield and Jordan (2010), a company aims at minimizing its cost of capital by choosing the optimal capital structure that maximizes the market value of an organization. The optimal capital structure results in the highest market capitalization and is associated with the lowest cost of capital. Hence, Alphabet can increase its intrinsic value by adding more debt to the capital mix.

Investment Project Evaluation

The company expands its investment activity through the growth of capital expenditures, as reported by Alphabet Inc. (2017). Thus, it is reasonable to consider different techniques applied to evaluate investment projects. As suggested by Brigham and Ehrhardt (2017), the key methods include net present value (NPV), internal rate of return (IRR), profitability index (PI) and payback period. However, each method has its own advantages and disadvantages. NPV provides the expected value from a project (Ross et al., 2010). It shows the net effect on the firm’s market that a project is expected to have. IRR indicates the internal rate of profitability of the project that helps in project ranking and evaluation. The payback period is used to measure the time needed for the project’s cash flows to cover the associated costs. According to Brigham and Ehrhardt (2017), NPV is the most adequate appraisal method that reveals the net value of a project that helps to assess the quantitative effect of the project on a firm’s value. Generally, projects with higher NPV are desirable, so that investing in these projects will have a positive impact on the organization’s value. Therefore, the company can increase its value by investing in the projects with higher risk-adjusted NPV since it is basically worth a portfolio of its projects. The higher the NPV of the portfolio, the greater the market value is projected to be.

Economic Value Added (EVA)

The value of investment portfolio of a corporation relates directly to its market value. Profitability of the portfolio has a strong impact on Alphabet’s overall profitability. A popular measure to gauge profitability of investment activity is the Economic Value Added (EVA). According to CFI (n. d.), EVA provides a measure of firm’s return over its cost of capital and is calculated as Net Operating Profit After Tax (NOPAT) minus capital invested adjusted for the organization’s cost of capital. Hence, EVA shows additional returns above WACC. Thus, the higher EVA is, the better. The growth in EVA is a positive sign for a company since it indicates the improved performance of its investment activity. Table 4 offers key financial data to estimate Alphabet’s EVA. The main financial metrics include capital invested, WACC, finance charge and EVA. Capital invested reveals the capital, which a business organization invests in its projects. WACC provides the firm’s cost of capital whereas the finance charge indicates the minimum value that a corporation should earn to cover its cost of capital. At this level, the level of EVA is zero. Hence, positive EVA is achieved only when a company generates NOPAT that is above the finance charge. As it is seen from Table 4, Alphabet’s NOPAT has been soaring in recent years from slightly more than $12 billion to about $18.5 billion. Moreover, the finance charge has been trending higher as well. As suggested by the estimation, EVA of the enterprise has escalated substantially since 2015 by more than 50% mainly because of the higher NOPAT. In addition, it is important to note that taxes and debt have a dual impact on EVA. On the one hand, the higher tax rate rewards a company with the lower cost of capital thereby increasing its EVA. On the other hand, the considerable tax rate reduces NOPAT and results in the lower EVA in the organization.

Conclusions and Recommendations

In summary, it has been found that Alphabet demonstrates good financial performance and relies heavily on debt as a source of financing. Besides, the corporation has excellent financial solvency since most of its capital comes from the equity of shareholders. The share of debt in the total capital of the corporation is low, so Alphabet can benefit by adding more debt to reduce its WACC. Furthermore, the firm has a capacity to increase its debt level, which is suggested by solid financial solvency. Thus, by adding more debt, Alphabet can lower WACC thereby increasing its intrinsic value. However, the firm should attract debt financing to finance value adding projects that provide higher returns than the cost of financing. Moreover, the paper ignores comparison with the industry that can reveal whether Alphabet has an adequate debt level.

Therefore, it is recommended that Google (Alphabet) manage a cost of capital by changing its capital structure to minimize WACC and invest only in solid projects that ensure adequate risk adjusted returns. The implementation plan for the company consists of a few steps. Firstly, Alphabet should determine key criteria for assessment of its investment projects. Secondly, the corporation should rank its projects by risk-adjusted NPV that they are expected to provide with compliance with its strategy and capabilities. Thirdly, Alphabet should structure financing for its investment activity to maximize the payoffs by raising capital through the combination of debt and equity that leads to optimal cost of capital. Consequently, this strategy is expected to achieve positive returns to shareholders and increase the organizational market value.

References

Alphabet. (2017). Alphabet 2017 Annual Report. Retrieved from https://abc.xyz/investor/pdf/20171231_alphabet_10K.pdf

Bodie, Z., Kane, A., & Marcus, A. J. (2013). Essentials of investments. New York, NY: McGraw-Hill Irwin.

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