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: PVAE ( Yr 0 ) = 1000 + And Thus: PVAE = 1132.2 150 - 100 220 - 115 + 1.1 1.12 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; PVAE ( Yr 0 ) = 1000 + 175 - 100 195 - 117.5 + 1.1 1.12 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; PVAE ( Yr 0 ) = 1000 + 200 - x - 100 220 - 50 + x - (1200 - x)0.1 + 1.1 1.12 ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 2 Capitalising And Amortising R&D (3) As: - x x 0.1 x + + =0 2 2 1.1 (1.1 ) (1.1 ) PVAE is thus independent of x and hence accounting policy for R&D expenditure! FINANCIAL INFORMATION ANALYSIS ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 3 Explain why terminal values in accounting-based valuation are significantly less than those for DCF valuation. ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 3 DCF terminal values include the PV of all expected CFs beyond the forecast horizon; The expected cash flows beyond the forecast horizon can be broken down into 2 parts: normal and abnormal; Since the terminal value in the PVAE includes only abnormal earnings, terminal values in accounting-based valuations are significantly less than those in DCF valuations; FINANCIAL INFORMATION ANALYSIS ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 5 Manufactured Earnings is a “Darling” of Wall Street analysts; Its current market price is $15 per share and its book value is $5 per share; Analysts forecast that the firm’s book value will grow by 10% per year, indefinitely, and the cost of equity capital is 15%; Given these facts, what is the market’s expectation of the long-term average ROE? ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 5 ve*/se = 1 + [ ( ROE - E ) / (E - g ) ] where: ROE is the expected long-term average ROE; g is the expected long-term average growth in book value; E is the cost of equity capital; ve* is the stock price; se is the book value of equity per share; ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 5 Equivalently: ROE = E + (E - g )* (ve*- se) / se And hence: ROE = 15% + ( 15% - 10% ) * ( 15 - 5 ) / 5 = 25% FINANCIAL INFORMATION ANALYSIS ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 6 Given the information in the previous question, what will be Manufactured Earnings’ stock price if the market revises its expectations of long-term average ROE to 20%? ACCOUNTING-BASED VALUATION TECHNIQUES Application Exercises Question 6 Using the same formula: ve*/se = 1 + (20% - 15%)/(15% - 10%) Hence: P = $10