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Accounting-Based Valuation Techniques

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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…...

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