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Accounting Treatment Effect on Valuation

This analysis explores the effects of different accounting treatments for R&D expenditures on a company's valuation. Starting with a $100 million annual investment in R&D since 2013, we analyze two scenarios: expensing R&D against income and capitalizing it over five years. Expected income, Return on Net Economic Assets (RNEA), and Return on Investment (REI) are computed for each method, revealing stark differences in initial negative values versus potential positive outcomes over time. We further forecast RNEA and REI for 2020 and discuss optimal depreciation methods impacting enterprise value.

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Accounting Treatment Effect on Valuation

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  1. Accounting Treatment Effect on Valuation Mitchell Schmitt

  2. Facts • $100 million investment in R&D each year beginning in 2013 • Each dollar spent generates $1.60 in revenue in each of the subsequent 5 years • Operating Expenses are equal to 80% of sales

  3. Part a. Calculate Expected Income, RNEA, and REI assuming R&D is expensed against Income

  4. Part b. Calculate RNEA and REI Amortizing R&D Expenditures Over 5 Years

  5. Compare Parts A and B Pt. a Pt. b As expected, the REI and RNEA of part a represent of a larger range in values. Initially, RNEA and REI are large, negative numbers due to the large expenditures that met the I/S in the early years. However, once 5 years worth of R&D investment began earning revenues each year, RNEA and REI are much greater because of the reduced expenses which provided a larger return on fewer capitalized assets.

  6. Part D- Forecast RNEA and REI for 2020 These forecasts differ due to the increased asset base that is shown on the Balance Sheet due to capitalization of R&D expenditures. A greater return is demanded for REI that is not overcome in this example because EPAT does not change between the two scenarios. Expensed R&D Capitalized R&D

  7. Value for Part A Using REI Model

  8. Value for Part B Using REI Values are equal, Accounting doesn’t change valuation

  9. Difficulty by forecasting through 2016 • Steady state would not be achieved • REI found when capitalizing assets would not match REI when expensing R&D

  10. Adjusted R&D Expenditures

  11. Comparison of RNEA Part a. Part g. Although sales are decreasing in for part g, EPAT is still higher due to the removal of expense from investment from R&D.

  12. Part 2:Depreciation Methods Forecasted EPAT and NEA using 3 year depreciation

  13. EPAT and NEA: 5 year depr.

  14. More Profitable at IPO • More profitable using 3 year depreciation • Largest investment is fully depreciated by 2017 • Depreciation expense lower as a result which leads to a larger EPAT

  15. Enterprise Value: 3 Year Depr

  16. Enterprise Value: 5 Year Depr.

  17. Market Response to Earnings • Market is not perfectly rational, may give higher value in response to higher reported earnings • Manipulating earnings may provide pop to initial stock price • Accounting does not effect valuation

  18. 2022: Founders’ Options Vest • Would want lowest possible expenses in these years to increase earnings • The optimal depreciation length would depend on the investment schedule • Ex: The 3 year method would be optimal for large investments made in 2018 (Would be fully depreciate by the vesting period)

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