It is now January 1, 2013. Google, Inc. is considering the purchase of Facebook, Inc. (the entire company) and has asked for your help in determining Facebook enterprise value.

Both Google and Facebook generate their revenue from advertising. Analysts predict that substantial synergies can be generated if the two companies merge. Google plans to operate Facebook as a separate company, but estimates that $500 million of incremental revenue per year will be generated by Facebook in 2013, 2014 and 2015 as a result of realizing synergies from the merger. Moreover, the Google executives expect that the Selling/General/Administrative Expenses of Facebook will be reduced by $250 million per year as a result of the proposed merger (in each of the years 2013, 2014 and 2015).

Google management further expects that net cash flow (or free cash flow) grow in nominal terms at the rate of 2% per year forever after the first three years. Google executives believe that the maximum price that the company should pay for Facebook is the present value of future expected cash flows following the merger.

Google has tried to acquire Facebook before but could not convince Mr. Mark Zuckerberg, the CEO and primary shareholder, to sell. However, following its initial public offering (IPO) of stock, Facebook has not done well so there is some possibility that Mr. Zuckenberg can be convinced to sell the company.

Facebook

Facebook filed for an IPO on February 1, 2012. The preliminary prospectus announced that the company had 845 million active monthly users and that its website featured 2.7 billion daily likes and comments. The filing did note that the company's increases in membership, as well as its income growth, were slowing and that the trend was likely to continue.

Prior to the IPO, in early May 2012, the company was aiming for a share price valuation in the range of $28 to $35 (which meant an equity value of $77 billion to $96 billion). On May 14, 2012, the company raised the target to $34 to $38 per share. Some investors even suggested a $40 valuation. Ultimately underwriters settled on a price of $38 per share. This price valued the equity at $104 billion, the largest valuation to date for a newly public company. Initial trading saw the stock shoot up to as much as $45. Yet after one day of trading, the share price was $38.23 only $0.23 above the IPO price. The stock had lost over a quarter of its starting value by the end of May 2012. This led the Wall Street Journal to call the IPO a "fiasco." The annual earnings for 2012 were also disappointing to many investors (see attached).

The following projections are made without considering the synergies that may happen as a result of acquisition. The latest analysis shows that the number of Facebooks daily active users, an important measure of engagement, is 900 million now (Jan 1, 2013). The analysis includes projections for the next three years. The number of users is expected to grow by 10%, 5% and 3% for 2013, 2014, and 2015 largely due to growing mobile users. However, growth rates could be as low as 0%. The company is expected to generate revenues of $4 per each active user in 2013, $5 in 2014, $6 in 2015. The cost of generating revenues will be $1 billion in 2013, 2014 and 2015. Selling/General/Administrative Expenses are expected to be $1.4 billion per year for the next three years. R&D expenses are expected to be $1 billion in 2013 but are expected to decline to $0.5 billion in 2014 and 2015. The company had no depreciation in the past, but is expected to have $100 million in depreciation expense per year in each of the next three years.

Facebook is an all equity financed company. Facebook beta equity is 2. The average annual market return for the past hundred years has been 10%; the average historical risk free rate over the same period has been 2.5%. The current 10-year treasury bond yield is 2%.

Facebook Inc.

Income Statement

(in millions)

	2012
Total Revenue	3,504
Cost of Revenue, Total	967
Selling/General/Admin. Expenses, Total	1,420
Research & Development	1,102
Total Operating Expense	3,489
Operating Income	15
Taxes (40%)	6
Net Income	9

1. Calculcate WACC for Facebook Company.

2. Please write out the future cash flows of Facebok for the next three years (2013-2015) and the first year after that (2016) including the synergies that would be generated after the merger. Calculate value of Equity (E) of Facebook.