Homework Analysis. Di (Wendy) Wang. 1. R&D. a) Calculate expected enterprise income, RNEA, and residual income for each year under GAAP accounting. b ) Calculate RNEA, and residual income for each year under R&D capitalization regime. c) Comparing the two accounting treatments.
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Di (Wendy) Wang
Under GAAP, R&D is expensed directly, resulting in a lower RNEA/REI in the earlier years. If R&D expenditures are capitalized and amortized, RNEA/REI is higher in earlier years.
Under GAAP, there is no R&D expenditure in 2020; therefore, the RNEA and REI in 2020 are higher. Under the capitalization method, the amortization of R&D is not finished in 2020, resulting in a higher expense, lower EPAT, lower RNEA, and lower REI.
e) Value the firm at the end of 2013 using the two different accounting treatments
Enterprise value is higher if R&D expenditure is capitalized because R&D is amortized to further periods during which discount factors are higher, resulting a higher present value of the enterprise.
The difficulty is that the growth rate of REI has not stabilized by 2016 under the capitalization method.
RNEA is higher even though sales are growing at a slower rate in 2016, 2017 and 2018 in the g) scenario because EPAT is higher when R&D expenditure is lower.
Forecast under the 3-year depreciation shows the firm to be more profitable in 2017 because depreciation expense in 2017 is $100 million higher when the assets are depreciated over 5 years.
d) The founders insist that 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?
The market value IPOs based on their intrinsic value, not their earnings at the time of the IPO. Earnings at one point can be easily manipulated while intrinsic values cannot. The market is efficient, and investors, especially large institutional investor, are smart.
e) The CFO points out that his and the founders’ stock options vest in 2022, not at the time of the IPO in 2018. He therefore suggests that the focus should be on profits expected to be reported in 2022. What arguments might be made to justify using one depreciation method over the other?
It’s better to depreciate the assets over 3 years because under this depreciation method, EPAT will have been stabilized at $1350 million for 3 years by 2022, increasing the chance of a good performance of the company’s stock in 2022.