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Homework Exercise

This paper analyzes the impact of different accounting methods for R&D expenditures - expensing versus capitalizing - on the firm's value and profitability. It compares the return on net assets (RNEA) and return on equity (REI) under both approaches, forecasting their outcomes until steady-state. The findings reveal that while lower initial income is observed with expensing, long-term revenue growth suggests greater benefits of the capitalizing method. Additionally, the choice of depreciation method (3-year vs 5-year) influences perceived profitability prior to IPO without affecting the intrinsic value of the firm.

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Homework Exercise

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  1. Homework Exercise Megan Morava

  2. Problem 1 • Accounting for R&D • Expensing vs. Capitalizing • Comparing RNEA and REI under both accounting methods • Value of the firm under each method • Forecasting until steady state

  3. Expensing R&D • Each dollar of R&D spent expected to generate $1.60 of revenue over each of the subsequent five years • R&D expense is $100 each year • Other expenses are 80% of sales

  4. Capitalizing R&D • R&D expenditures are no longer constant, instead capitalized and amortized over a five year period

  5. Comparison of RNEA and REI • RNEA and REI much lower under expensing than capitalizing at start, but ends up being much greater in later years • This is because under the expensing method, enterprise income is much lower in early years • However, NEA is much greater under capitalizing method, causing RNEA and REI to be lower comparatively in later years

  6. RNEA and REI forecasted in 2020 • RNEA and REI are higher under the expensing method than the capitalizing method in 2020 • This is caused by higher NEA under the capitalizing method • 80 vs. 280

  7. Valuing the Firm • The value of the firm is the same under both accounting treatments • Income shifting does not change intrinsic value of the firm • If you only forecasted to 2016, steady-state would not be reached (REI growth does not equal 0%) and the true enterprise value would not be reflected

  8. Part g • RNEA is higher even though revenue is growing at a slower rate • This is caused by higher net income starting in 2016 and onward • Lower income driven by less R&D expense in later years

  9. Problem 2 • Forecasts of EPAT and NEA under 3-year vs. 5-year depreciation method • Which method shows the firm to be more profitable in 2017 before the IPO? • Depreciation method does not affect intrinsic value of firm

  10. EPAT and NEA: 3-year vs. 5-year

  11. Depreciation Method & Intrinsic Value

  12. Analysis • 5-year depreciation shows firm to be more profitable in 2017, just prior to IPO • 388.50 vs 488.50 • Caused by lower depreciation expense under 5-year depreciation method • Depreciation method does not change intrinsic value of the firm • While the market may look to earnings, the intrinsic value of the firm doesn’t change so it should not affect IPO • Profits will be equal in 2022 when stock options vest • Argument for 3-year depreciation method, because depreciation is accelerated, causing great tax benefits

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