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Homework Exercise 1. Kevin Overholt 4/9/2014. GAAP Valuation. Modified GAAP Valuation. Differences between GAAP and Modified GAAP. The RNEA and Residual Enterprise Income have a much steeper growth rate using GAAP accounting as compared to capitalizing the R&D costs.
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Homework Exercise 1 Kevin Overholt 4/9/2014
Differences between GAAP and Modified GAAP • The RNEA and Residual Enterprise Income have a much steeper growth rate using GAAP accounting as compared to capitalizing the R&D costs. • Capitalizing the costs better matches the revenues with the applicable expenses, creating a smoother growth rate.
2020 Projections – GAAP and Modified GAAP • These forecasts differ solely due to the capitalization of the R&D. Because Residual Income is derived from NEA, changing NEA through R&D capitalization will cause a permanent difference. • Modified GAAP will have a smaller steady state residual income level than normal GAAP. • Modified GAAP will also have smaller losses in earlier years.
Forecasting up to 2016 • By only forecasting up to the year 2016, we would reach much different conclusions. • The enterprise value appears much more attractive if R&D was capitalized, as the enterprise value (without considering forecasts subsequent to 2016) is just -$64.21, compared to -$214.47 given standard GAAP accounting. • As stated before, the losses are much greater in GAAP accounting in the early years of the forecast, as the full $100 of the R&D is expensed each year vs. just $20. • Having the continuing value is essential to proper valuation.
Declining R+D Model • Greater Residual Enterprise Income because of lower expenses in 2016-2020 combined with equal revenue streams as the prior model.
Differences in 3 vs. 5 Year Depreciation • The longer depreciation method, again, creates smaller losses in the first few years, but also has smaller profits in the steady state. • The enterprise value at t=0 is exactly the same, the differences in accumulated depreciation just serve to manipulate earnings in different ways. • In 2017, the 5-year method appears to be more profitable in the current year. The expenses are lower in this month as the amortized amount is spread over a longer period.
Intrinsic Value Conclusion • From using the residual enterprise income model, we see that the intrinsic value of the firm is exactly the same, given the two different methods of depreciation. • Again, the differences in depreciation are only temporary, and are eventually evened out over the long run. • If allowable, the controller could manipulate current and future earnings by changing the depreciation method. • For example, if higher earnings are desired in future years, choose the 3-year method. If smaller losses are desired now, choose the 5-year method. • It can be concluded that the intrinsic value of the firm, and therefore the IPO value of the firm at any point, should not be affected by any of these methods, as the underlying processes are exactly the same. • Assuming informed investors, etc.