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Homework Exercise 4/09/14

Homework Exercise 4/09/14. Jeff Ritter. Agenda. Question 1 Question 2. Question 1. Information Provided. Question 1.

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Homework Exercise 4/09/14

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  1. Homework Exercise 4/09/14 Jeff Ritter

  2. Agenda Question 1 Question 2

  3. Question 1 Information Provided

  4. Question 1 a) Calculate enterprise income, return on net enterprise assets (RNEA), and residual enterprise income for each year, 2014 to 2019 under GAAP Accounting (R&D expensed). Enterprise Income Revenue: : 2014: 100*1.6 2015: 200*1.6 2016: 300*1.6 2017: 400*1.6 2018: 500*1.6 2019: 500*1.6 “$1.60 of revenue over of the subsequent five years for every $1 of R&D” Research and Development costs are expensed under GAAP

  5. Question 1 a) Calculate enterprise income, return on net enterprise assets (RNEA), and residual enterprise income for each year, 2014 to 2019 under GAAP Accounting (R&D expensed). RNEA RNEA: 2014: -68/80 2015: -36/80 2016: -4/80 2017: 28/80 2018: 60/80 2019: 60/80 “$1.60 of revenue over of the subsequent five years for every $1 of R&D” Assumption: Net operating assets (NEA) are constant at 80 based on the information provided. (Average not necessary because no change)

  6. Question 1 a) Calculate enterprise income, return on net enterprise assets (RNEA), and residual enterprise income for each year, 2014 to 2019 under GAAP Accounting (R&D expensed). Residual Enterprise Income REI: 2014: -68-80*.1 2015: -36-80*.1 2016: -4-80*.1 2017: 28-80*.1 2018: 60-80*.1 2019: 60-80*.1 EPAT-NEAt-1*Required Return

  7. Question 1 b) Now calculate the RNEA and residual enterprise income for each year under an accounting regime that capitalizes R&D expenditures and amortizes them over five years. RNEA NEA Addition to assets + 80 from given info RNEA: 2014: -8/80 2015: 4/80 2016: 16/80 2017: 28/80 2018: 60/80 2019: 60/80 R&D Expense for each year: Prior years cumulative R&D until five years reached X 1/5 2014: 200* 1/5 2015: 300* 1/5 2016: 400*1/5 2017: 500*1/5 Assumption: Net operating assets (NEA) are constant at 80 based on the information provided. (Average not necessary because no change)

  8. Question 1 b) Now calculate the RNEA and residual enterprise income for each year under an accounting regime that capitalizes R&D expenditures and amortizes them over five years. REI: 2014: -8-160*.1 2015: 4-220*.1 2016: 16-260*.1 2017: 28-280*.1 2018: 60-280*.1 2019: 60-280*.1 EPAT-NEAt-1*Required Return

  9. Question 1 c) Compare the RNEA and residual enterprise income calculated under the two accounting treatments for each year. Why are they different? Expense Capitalize EPAT NEA Different accounting methods RNEA • Expensing R&D significantly lowers income and NEA is lower than it would be if R&D was capitalized Thus, the greater impact on income and lower NEA for expensing R&D will result in in a greater fluctuation before steady state and a higher RNEA after steady state is reached. • Capitalizing R&D raises income because it is amortized over time and NEA is higher than it would be if R&D was expensed.

  10. Question 1 d) Forecast RNEA and residual enterprise income for 2020 under the two accounting treatments. Why do these forecasts differ? • Residual enterprise income is different because lower book values present in the expensing example leads to higher future income. • RNEA is smaller because the R&D was capitalized which increases the denominator of the equation NEA. This larger NEA, thus makes the RNEA smaller as compared to expensed R&D which does not affect NEA.

  11. Question 1 e) Value the firm at the end of 2013 using the two different accounting treatments. Do the valuations differ? Why? • No, the valuations do not differ because accounting choices should not affect valuations as the underlying economic transaction has not changed. Income shifting between periods has no effect on value calculated. The NEA anchors the valuation.

  12. Question 1 f) If you tried to value this firm by forecasting only to 2016, what difficulties would you face under the two methods? • The major difficulty would pertain to steady state. Steady state is not reached by 2016, which impacts the valuation of the firm under the two methods because properly forecasting the continuing value would be difficult.

  13. Question 1 g) Return to GAAP accounting (expense) and suppose the firm expects to cut R&D by $20 million from 2016 to 2019. This results in $0 R&D for 2020. RNEA is higher and sales are growing slower why? • Sales are growing slower because R&D generates sales. Every $1 of R&D generates $1.60 in sales. The reduction in R&D expenditures is reducing sales. Return on net enterprise assets is higher because net assets are not changing (the denominator) while Enterprise income is increasing (the numerator) because less expense.

  14. Question 2 a) Prepare forecasts of EPAT and NEA under both depreciation methods. Ignore Tax effects.

  15. Question 2 a) Prepare forecasts of EPAT and NEA under both depreciation methods. Ignore Tax effects.

  16. Question 2 a) Prepare forecasts of EPAT and NEA under both depreciation methods. Ignore Tax effects.

  17. Question 2 b) Which set of forecasts show the firm to be more profitable in 2017, just prior to the anticipated public offering? Why? • The five year depreciation shows the firm to be more profitable because the expense is being shifted into later periods as compared to the three year depreciation.

  18. Question 2 c) Show that the depreciation method does not affect the intrinsic value Residual Enterprise Income Model

  19. Question 2 c) Show that the depreciation method does not affect the intrinsic value Residual Enterprise Income Model Both depreciation methods have the same Enterprise value of $1,807.

  20. Question 2 d) Founders insist the market will give a higher value if higher earnings are reported. How would you reply? • The calculations clearly illustrate the enterprise value is the same for both depreciation methods. Accounting choice does not affect the valuation of the firm in the market. Depreciation is self correcting in accounting. Income shifting between periods has no affect on value calculated.

  21. Question 2 e) Stock options vest in 2022, not in time for the IPO in 2018. What arguments might be made to justify using one depreciation method over another? • The one argument that could be made is that residual income is higher for the three year depreciation method at $250 vs %150. If residual income is higher in 2022 there will be more income available for these stock options. • If overall value is considered in regards to tax benefits, the accelerated depreciation may be advantageous.

  22. Any Questions?

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