R&D - Research and Development Expenses...

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Research and Development Expenses: Implications for Profitability Measurement and Valuation Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 [email protected]
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Abstract Most valuation models begin with a measure of accounting earnings to arrive at cash flow estimates. When using accounting earnings, we implicitly assume that the income is obtained by netting out only those expenses that are operating expenses, i.e., expenses designed to generate revenues in the current period. Expenses that are intended to provide benefits over multiple periods are assumed to be considered as capital expenditures, and these expenses are depreciated or amortized over multiple periods. In addition, when computing profitability measures such as return on equity and capital, we stick with this assumption that operating income measures income generated by assets in place. In this paper, we examine the accounting treatment of research and development expenses, and the effects of the treatment on operating income, capital and profitability. We argue that research and development expenses should be treated as tax-deductible capital expenditures, for purposes of valuation, and this can have significant effects on operating income, capital and expected growth measures for firms with substantial research expenses.
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The operating income for a firm is estimated by netting out all operating expenses from revenues. When valuing a firm, we usually begin with after-tax operating income and then reduce it by the reinvestment needs of the firm. The reinvestment needs cover any investments that the firm needs to make to generate future growth, and include both capital expenditures and working capital investments. The distinction between operating and capital expenditures is critical for tax calculations, and is important in determining both the amount of capital on a firm's books and how its profitability is measured. In this paper, we will consider the accounting treatment of research and development expenses as operating expenses, and argue that it is not appropriate to do so, at least for valuation purposes. Considering research and development expenses as capital expenses will have profound effects on estimates of cash flow and growth in valuation, and in determining earnings multiples for purposes of relative valuation. Operating and Capital Expenditures Accounting statements classify all expenses into three categories - operating expenses, financing expenses and capital expenses. Operating expenses are expenses that, at least in theory, provide benefits only for the current period; the cost of labor and materials expended to create products which are sold in the current period would be a good example. Financing expenses are expenses arising from the non-equity financing used to raise capital for the business; the most common example is interest expenses.
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This note was uploaded on 01/08/2010 for the course ACC 551 taught by Professor None during the Spring '09 term at Ill. Chicago.

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R&D - Research and Development Expenses...

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