Here are some details of an investment in a project with a two-year life and a required return of 9 percent per year. Dollar amounts are in millions.
Initial investment in equipment...........$1,500
Initial investment in advertising........... 700
Total investment................$2,200
Expected revenue, year 1..............$1,540
Expected revenue, year 2..............$1,540
All revenue is received in cash. Investments are depreciated using the straight-line method.
a. Value the project and its value added using discounted cash flow techniques.
b. Value the project using residual earnings techniques with the total initial investment capitalized on the balance sheet. Also calculate expected return on net operating assets (RNOA) for each period.
c. Repeat part b of the question, but with depreciation of $1,300 million in Year 1. Explain why numbers differ. How does the value of the investment change?
d. Repeat the valuation using straight-line depreciation but with the initial investment in advertising expensed immediately, as required by GAAP.
e. Compare the price-to-book ratio and the forward P/E ratio under the alternative accounting treatments for investments in advertising.