E16.5. The Accounting for Research and Development and Economic Profit Measures (Medium) Many consultants recognize that expensing R&D investments gives a poor indication of the performance of a firm or its managers because investing in R&D results in lower in- come. So they adjust GAAP accounting by capitalizing R&D expenditures and amortiz- ing the capitalized amount over the estimated life of the revenues that flow from the ex- penditures.

a. Below is a series of R&D expenditures that are expected for the years 2009 to 2014 under a firm's R&D program (in millions of dollars). The R&D program began in 2008 with a $100 million investment. Expected net operating assets for the firm are also given for net assets other than those created by the R&D expenditures. Expenditures for R&D are expected to generate $1.60 of revenue over each of the subsequent five years for each dollar spent. Expenses other than R&D expenses are expected to be 80 percent of sales. 2008A 2009E 2010 2011E 2012E 2013E 2014E R&D expenditure Net operating assets 100 80 80 100 100 80 100 80 100 100 100 80 BO 80 Calculate expected operating income, return on net operating assets (RNOA), and residual operating income for each year, 2009 to 2014, under GAAP accounting (where R&D expenditures are expensed against income). Use a required return for operations of 10 percent.

b. Now calculate the RNOA and residual operating income for each year under an ac- counting that capitalizes R&D expenditures and amortizes them over five years.

c. Compare the RNOA and residual operating income calculated under the two account- ing treatments for each year. Why are they different?

d. Forecast RNOA and residual operating income for 2015 under the two accounting treatments. Why do these forecasts differ?

e. Value the firm at the end of 2008 using the two different accounting treatments. Do the valuations differ? Why?

f. If you tried to value this firm by forecasting only to 2011, what difficulties would you face under the two methods?