Answer this question based on the article given below

a.Briefly discuss the role of financial modeling and whether it played an important part of not? In hindsightdo you think it was a good deal and why?

Google Buys YouTube: A Firm Without Cash Flows

YouTube ranks as one of the most heavily utilized sites on the Internet, with one billion views per day, 20 hours of new video uploaded every minute, and 300 million users worldwide. Despite the explosion in usage, Google continues to struggle to "monetize" the traffic on the site five years after having acquired the video sharing business. 2010 marked the first time the business turned marginally profitable. Whether the transaction is viewed as successful depends on whether it is evaluated on a stand-alone basis or as part of a larger strategy designed to steer additional traffic to Google sites and promote the brand.

This case study illustrates how a value driver approach to valuation could have been used by Google to estimate the potential value of YouTube by collecting publicly available data for a comparable business. Note the importance of clearly identifying key assumptions underlying the valuation. The credibility of the valuation ultimately depends on the credibility of the assumptions.

Google acquired YouTube in late 2006 for $1.65 billion in stock. At that time, the business had been in existence only for 14 months, consisted of 65 employees, and had no significant revenues. However, what it lacked in size it made up in global recognition and a rapidly escalating number of site visitors. Under pressure to continue to fuel its own meteoric 77 percent annual revenue growth rate, Google moved aggressively to acquire YouTube in an attempt to assume center stage in the rapidly growing online video market. With no debt, $9 billion in cash, and a net profit margin of about 25 percent, Google was in remarkable financial health for a firm growing so rapidly. The acquisition was by far the most expensive acquisition by Google in its relatively short eight-year history. In 2005, Google spent $130.5 million in acquiring 15 small firms. Google seemed to be placing a big bet that YouTube would become a huge marketing hub as its increasing number of viewers attracts advertisers interested in moving from television to the Internet.

Started in February 2005 in the garage of one of the founders, YouTube displayed in 2006 more than 100 million videos daily and had an estimated 72 million visitors from around the world each month, of which 34 million were unique.[1]As part of Google, YouTube retained its name and current headquarters in San Bruno, California. In addition to receiving funding from Google, YouTube was able to tap into Google's substantial technological and advertising expertise.

To determine if Google would be likely to earn its cost of equity on its investment in YouTube, we have to establish a base-year free cash-flow estimate for YouTube. This may be done by examining the performance of a similar but more mature website, such as about.com. Acquired byThe New York Timesin February 2005 for $410 million, about.com is a website offering consumer information and advice and is believed to be one of the biggest and most profitable websites on the Internet, with estimated 2006 revenues of almost $100 million. With a monthly average number of unique visitors worldwide of 42.6 million, about.com's revenue per unique visitor was estimated to be about $0.15, based on monthly revenues of $6.4 million.[2]

By assuming these numbers could be duplicated by YouTube within the first full year of ownership by Google, YouTube could potentially achieve monthly revenue of $5.1 million (i.e., $0.15 per unique visitor 34 million unique YouTube visitors) by the end of year. Assuming net profit margins comparable to Google's 25 percent, YouTube could generate about $1.28 million in after-tax profits on those sales. If that monthly level of sales and profits could be sustained for the full year, YouTube could achieve annual sales in the second year of $61.2 million (i.e., $5.1 12) and profit of $15.4 million ($1.28 12). Assuming optimistically that capital spending and depreciation grow at the same rate and that the annual change in working capital is minimal, YouTube's free cash flow would equal after-tax profits.

Recall that a firm earns its cost of equity on an investment whenever the net present value of the investment is zero. Assuming a risk-free rate of return of 5.5 percent, a beta of 0.82 (per Yahoo! Finance), and an equity premium of 5.5 percent, Google's cost of equity would be 10 percent. For Google to earn its cost of equity on its investment in YouTube, YouTube would have to generate future cash flows whose present value would be at least $1.65 billion (i.e., equal to its purchase price). To achieve this result, YouTube's free cash flow to equity would have to grow at a compound annual average growth rate of 225 percent for the next 15 years, and then 5 percent per year thereafter. Note that the present value of the cash flows during the initial 15-year period would be $605 million and the present value of the terminal period cash flows would be $1,005 million. Using a higher revenue per unique visitor assumption would result in a slower required annual growth rate in cash flows to earn the 10 percent cost of equity. However, a higher discount rate might be appropriate to reflect YouTube's higher investment risk. Using a higher discount rate would require revenue growth to be even faster to achieve an NPV equal to zero.

Google could easily have paid cash, assuming that the YouTube owners would prefer cash to Google stock. Perhaps Google saw its stock as overvalued and decided to use it now to minimize the number of new shares that it would have had to issue to acquire YouTube, or perhaps YouTube shareholders simply viewed Google stock as more attractive than cash.

With YouTube having achieved marginal profitability in 2010, it would appear that the valuation assumptions implicit in Google's initial valuation of YouTube may, indeed, have been highly optimistic. While YouTube continues to be wildly successful in terms of the number of site visits, with unique monthly visits having increased almost six-fold from their 2006 level, it appears to be disappointing at this juncture in terms of profitability and cash flow. The traffic continues to grow as a result of integration with social networks such as Facebook and initiatives such as the ability to send clips to friends as well as to rate and comment on videos. Moreover, YouTube is showing some progress in improving profitability by continuing to expand its index of professionally produced premium content. Nevertheless, on a stand-alone basis, it is problematic that YouTube will earn Google's cost of equity. However, as part of a broader Google strategy involving multiple acquisitions to attract additional traffic to Google and to promote the brand, the purchase may indeed make sense.