Homework Exercise. 04/09/2014 Sherry Xu ( netID : jxu6). Question 1-Assumptions. Question 1-a. Question 1 -b. Question 1-c. Different accounting treatments result in different R&D/amortization expense as well as NEA .
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Forecasts differ because there is no R&D expenditure in 2020.
Enterprise value calculated under both a. and b. is the same. This is true because accounting choices do not affect valuation. The underlying economic transaction has not changed, so the value will not change.
If we value this firm by forecasting only to 2016, the enterprise value calculated using accounting numbers of different accounting treatment will differ, because the firm has not reached steady state.
RNEA is increasing while sales are growing at a slower rate and decreasing in 2019. NEA is constant over the years, and the increasing RNEA is due to increasing EPAT, which is due to less R&D expense. The decrease in R&D expense outweighs the slower growth in sales.
The firm looks more profitable under 5-yr depreciation in 2017. This is because longer asset life leads to lower depreciation expense and thus increases the income.
Note: Under 3-yr depreciation, the firm reaches steady state in 2020, while under 5-yr depreciation in 2022. The annual total depreciation expense will be $1000 2020 onwards under 3-yr and 2022 onwards under 5-yr.
d.: Accounting choices should not affect the value of the firm. Therefore, the market will value the firm the same no matter what accounting treatment the firm uses.
e.: Profit reported after 2022 will be the same under both depreciation methods. However, according to the matching principle of financial reporting, expense should match revenue. Therefore, management should use the asset life assumption that better matches with revenue generation.
Sherry Xu (netID: jxu6)