Financial Information Analysis Accounting-Based Valuation Techniques

FINANCIAL INFORMATION ANALYSIS

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Construct a two-period numerical example to show that the accounting-based valuation of a firm is the same whether R&D is capitalized or expensed.

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Consider R&D Inc., a biotech start up. This firm:

• Incurs expenditures in R&D of $50 in the first year of activity;

• Has an opening book value of equity of $1,000;

• Generates income (before R&D expenses) of $200 in year 1 and $220 in year 2, at the end of which it is liquidated;

• Has a cost of equity capital of 10%;

• Pays no dividends prior to liquidation;

Show that the PVAE obtains regardless of whether R&D Inc. expenses R&D expenditure as incurred or capitalizes and amortizes R&D expenditure!

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Expensing R&D As Incurred

Assume that the R&D expenditure is expensed at the end of year1:

[pic]

And Thus:

PVAE = 1132.2

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Capitalising And Amortising R&D (1)

Assume that the R&D expenditure is capitalised and amortised linearly:

• R&D expense recognised at end of year 1: 25;

• R&D expense recognised at end of year 2: 25;

[pic]

And thus:

PVAE = 1132.2

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Capitalising And Amortising R&D (2)

Assume that the R&D expenditure is capitalised and amortised as follows:

• R&D expense recognised at end of year 1: x;

• R&D expense recognised at end of year 2:

• 50-x;

[pic]

ACCOUNTING-BASED VALUATION TECHNIQUES

Application Exercises

Question 2

Capitalising And Amortising R&D (3)

As:

[pic]

PVAE is thus independent of x and hence accounting policy for R&D expenditure!

FINANCIAL INFORMATION ANALYSIS

ACCOUNTING-BASED VALUATION TECHNIQUES...