Homework Exercise

Homework Exercise Carl Brinker 4/9/2014

Question 1 – Requirement A

Question 1 – Requirement B Finding NEA: Finding RNEA and REI:

Question 1 – Requirement C • RNEA and Residual Income are more volatile if R&D is expensed • EPAT is more volatile under expensing method • Capitalizing R&D better matches revenues with the expendituresincurred to generate those revenues • Under capitalization, expenses (and NEA) growth with revenueand stabilize RNEA and REI calculations

Question 1 – Requirement D • Forecasts were average RNEA and REI, as per Module 4 • The expense method yields more aggressive forecastsbecause RNEAand REI anchor on NEA • The capitalization method increases the NEA that RNEA and REIare calculated upon • Anchoring on a smaller NEA allows for higher forecasts under theexpense method

Question 1 – Requirement E Perpetual Sales Growth is 0%; R&D expenditures are constant, so revenueflows will be constant as well. Total Value: $334

Question 1 – Requirement E Residual Income Valuation under the Capitalization Method yields anidentical value: $334 This makes sense: accounting method cannot affect value

Question 1 – Requirement F • Valuing only to 2016 would yield in different results • This is because the valuation models have not reached steady state • Under this scenario, the different accounting methods have not “zero’d out”

Question 1 – Requirement G New Revenue Calculation: New EPAT Calculation:

Question 1 – Requirement G • RNEA increases through 2019 even though revenue slows • This is because EPAT continues to grow as revenue slows; lower expensetaken for R&D in current years compared to revenue generated from prior-year expenses causes this trend • In other words, R&D expense decreases slower than revenue decline,maintaining high EPAT levels

Question 2 – Requirement A

Question 2 – Requirement B The three-year depreciation method makes the company appear more profitable in 2017. This occurs because management has expedited the depreciationof the major investment ($600 mil) to be expensed prior to 2017 in its entirety.

Question 2 – Requirement C Valuation from free cash flow models yields identical results. This is becausefree cash flow (EPAT – change in NEA) is the same regardless of depreciationmethodology. Intrinsic value is the same under each depreciation scheme.

Question 2 – Requirement D Aren’t higher earnings at IPO a higher value to the company? This may be true. Higher earnings at IPO may lead investors to expect higher earnings in the future and thus the stock price at IPO will be higher. However, reporting higher earnings at the time of IPO may mean sacrificing earnings in the years following the IPO. If earnings suffer post-IPO, stock price may decline. Importantly, the valuations I presented represented intrinsic value, not market value. Ultimately, depreciation periods should accurately reflect the useful life of the asset. Failure to do so may result in regulatory fines and penalties and a tarnished reputation in the marketplace.

Question 2 – Requirement E According to the depreciation forecast, the company should realize identical profits in 2022 because all depreciation related to the project will be taken by then under either method. Arguably, the founders and CFO should focus on maximizing sales and minimizing expenses from operations because these will directly impact profits (and stock price) in 2022. That said, analysts usually look at trends in profitability when valuing firms. Under the three-year forecast, EPAT stagnates from 2020 through 2022. In contrast, EPAT shows smooth growth under a 5-year depreciation assumption. From this perspective, the founders and CFO should prefer the five-year depreciation plan because projections based off of EPAT trends may be higher.

Questions?

Homework Exercise