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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).

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question 1 a
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 a1
Question 1(a)
  • Expected enterprise income
question 1 a2
Question 1(a)
  • Expected RNEA
question 1 a3
Question 1(a)
  • Expected residual income
question 1 b
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 b2
Question 1(b)
  • Residual enterprise income
question 1 c
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
Question 1(d)
  • Forecast RNEA for 2020 under the two accounting treatments
question 1 d1
Question 1(d)
  • Forecast REI for 2020 under the two accounting treatments
question 1 d2
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
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
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
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
Question 2(a)
  • EPAT and NEA under 3y depreciation model
question 2 a1
Question 2(a)
  • EPAT and NEA under 5y depreciation model
question 2 b
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
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
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
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