Homework Exercise

Homework Exercise ACCT 70311

Question 1 (a) • Calculate expected enterprise income, RNEA, and residual enterprise income for each year, 2014 – 2019 under GAAP accounting (where R&D expenditures are expensed against income)

Question 1(a) • Expected enterprise income

Question 1(a) • Expected RNEA

Question 1(a) • Expected residual income

Question 1(b) • Now calculate the RNEA and residual enterprise income for each year under he accounting regime that capitalized R&D expenditures and amortizes them over five years

Question 1(b) • RNEA

Question 1(b) • Residual enterprise income

Question 1(c) • Why are RNEA and residual enterprise income for each year different under the two accounting treatments? • Two major differences: • Under the capitalization approach, deferring depreciation results in a higher EPAT in early years, which favorably affects RNEA and REI • Under the expense approach, large R&D amortization expenses do not occur, which allows for greater RNEA and REI in later years

Question 1(d) • Forecast RNEA for 2020 under the two accounting treatments

Question 1(d) • Forecast REI for 2020 under the two accounting treatments

Question 1(d) • Why do RNEA and REI forecasts differ for 2020? • Forecasts differ because each approach has reached an equivalent steady state for EPAT, but NEA is larger for the capitalized approach because unamortized prior years’ R&D is included as an asset

Question 1(e) • Value the firm at the end of 2013 using the two different accounting treatments • Each approach yields same value • They have each reached steady state

Question 1(f) • If you tried to value this firm by forecasting only to 2016, what difficulties would you face under the two methods? • Steady state would not be reached • REI model would not yield an accurate valuation

Question 1(g) • When R&D is expensed, RNEA is higher despite sales growing at a slower rate in 2016 – 2018 and decreasing in 2019 for two reasons: • R&D expenses are decreasing • Sales are higher than pre-2016 years because more revenue is being generated from the investment in R&D (earlier investments plus current investment)

Question 2(a) • EPAT and NEA under 3y depreciation model

Question 2(a) • EPAT and NEA under 5y depreciation model

Question 2(b) • The forecasts encompassing a 5y estimated life show the firm to be more profitable in 2017 • Why? • Sales are the same under each approach; expenses are less under 5y approach • Investment in plant and equipment is gradually increasing through 2017 • 5y life depreciates 1/5 of each of the past four years’ investment in 2017 • 3y life depreciates 1/3 of each of the past three years’ investment in 2017

Question 2(c) • Calculations to show depreciation method does not affect intrinsic value of firm at the time of the IPO (early 2018)

Question 2(d) • Despite your calculations, the founders insist the market will give a higher value if higher earnings are reported at the time of the IPO. What would be your reply to them? • “I understand your viewpoint sir [or ma’am] (depending on gender of the founder making claim)…” • Five-year depreciation would make earnings higher at the time of IPO • But, the market places strong emphasis on future earnings potential in their valuation of a company • The intrinsic value is the same under either approach

Question 2 (e) The CFO suggests that the focus should be on profits in 2022 (year options vest). What arguments might be made to justify using one depreciation method over the other? • The depreciation method does not affect intrinsic value • Stock price should be same under each method • But, some investors value stock based on earnings multiples • In year of IPO (through 2021) expected earnings are greater if using a 5y depreciable life • Should result in a higher stock price if using multiples • Under 5y depreciable life, earnings will decrease from IPO (2018) through year stock options vest (2022) • The earnings are identical under each depreciation method in 2022, but downward trend in earnings could decrease the stock price if uninformed investors presume the company is deteriorating • It is best to use the depreciation period that most closely represents the assets’ useful economic life

Homework Exercise