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Homework Exercise

Homework Exercise . Kevin Pribil. Agenda. R&D Brief introduction Answers to A-G Depreciation Brief Introduction Answers to A-E. R&D. Managers are incentivized to capitalize R&D investments that should be expensed under GAAP

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Homework Exercise

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  1. Homework Exercise Kevin Pribil

  2. Agenda • R&D • Brief introduction • Answers to A-G • Depreciation • Brief Introduction • Answers to A-E

  3. R&D • Managers are incentivized to capitalize R&D investments that should be expensed under GAAP • How does this effect the enterprise valuation under the Residual Enterprise Income Model? • …

  4. Requirement A • Calculate expected enterprise Income • Calculate return on net enterprise assets (RNEA) • = EPAT/ avg(NEA)

  5. Requirement A (cont.) • Calculate residual enterprise income

  6. Requirement B • Calculate RNEA • Calculate residual enterprise income

  7. Requirement C • RNEA and residual enterprise income are both higher when management chooses to expense R&D against income • They are different because when management capitalizes and amortizes R&D, expenses decrease. • Only amortization effects income, not R&D

  8. Requirement D • Forecasts for 2020 are different because amortization is different than the expense they expect to incur.

  9. Requirement E • The valuations differ • Under GAAP accounting, enterprise value is- • $454 • Under non-compliant GAAP account, it is- • $359

  10. Requirement F • If forecasted only until 2016, the amortization would not have become stable yet • This would have skewed the enterprise valuation

  11. Requirement G • RNEA is higher because R&D expenditures generate $1.60 worth of revenue per dollar spent • Other expenses do not generate as much revenue

  12. Depreciation • A firm is evaluating a decision to begin manufacturing a new communications device in 2013 • The firm is planning an IPO in 2018 and wants to ensure books look attractive to investors in 2018 • How should the CFO estimate useful lives of the investment needed for this project? • Must also consider attractiveness at time of IPO

  13. Requirement A • Forecasts assuming 3-Year depreciation

  14. Requirement A (cont.) • Forecasts assuming 5-Year depreciation

  15. Requirement B • 5-Year depreciation schedules show Net Income to be higher in 2017 • In the 5-year schedule, less depreciation expense has been deducted from net income because over 5-year depreciation, the annual expense is less

  16. Requirement C 3-Year 5-Year

  17. Requirement D • The founders insist the value will be higher because the reported income value will change and be more/less attractive to investors • However, depreciation is a non-cash expense and essentially does not affect the value of the company because, regardless, the depreciation will be accounted for

  18. Requirement E • Using shorter-term depreciation may aesthetically have an increase in IPO share-price. • Typically, IPO’s have minimal returns after the opening day. • I believe that, regardless, the IPO price won’t be correlated with a share price in 2022. • Based on managements beliefs, 3-year depreciation will have a higher expense in the short-term leading to potentially higher share price in 2022.

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