Assuming a new accounting rule allows capitalisation of R&D, and your firm is investing heavily in R&D, what would be the effect on firm value?
Came across this in an old forum post (about 10 years back) and wasn't answered particularly definitively. I think the net cash position on CFS remains the same, but if capitalised, your firm value increases from the tax deductibility of R&D? Sort of like D&A? I think I may be on the right track with the comparison to D&A, but it'd be great if someone could clearly outline the impact on valuation.
EDIT: Okay I just had a think through it, and I think that it will reduce firm value because you lose out on the tax deductible effect of having it embedded in your SG&A, in the case of an unlevered FCF, and instead incurring the full cost on your cash flow for that year. Would this be correct?
I would say changing R&D from expensing to capitalizing decreases valuation from a DCF perspective.
If you expense the R&D right away, assume that you will have EBITR (Earnings before interest, tax and R&D) of 200 and an R&D expense of 100. You will end up with an EBIT of 100. At a 50% tax rate, you will have NOPAT (and free cash flow ignoring depreciation, CAPEX and changes in NWC) of 50 in the first year. Since you expense it right away, there is no cash outflow from investment activities. In the following year, you will have EBIT of 200 (assume no growth) and at a 50% tax rate, you will have NOPAT of 100 (and free cash flow ignoring depreciation, CAPEX and changes in NWC).
If you capitalize it, you will have EBITDA of 200, and EBIT of 180 (5-year depreciation @20 each year). At 50% tax rate, you will have NOPAT of 90. Since you capitalize it, you will record it as an asset and there will be a cash outflow of 100 from investing activities. Free cash flow will be 90 + 20 (depreciation) – 100 = 10 for the first year. For the following years, you will have EBITDA of 200, EBIT of 180. At 50% tax, you will have a NOPAT of 90. Free cash flow will be 90 + 20 (depreciation) for the next 4 years. So, in the first case, you have the additional 40 dollars right away, whereas in the second case, you will have it as 10 dollars each year for the next 4 years. So, whatever the discount rate, capitalizing decreases valuation.