Trick (?) Technical Question

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?

Comments (16)

Sep 20, 2018

If you capitalize it wouldn't that mean it would reduce your expenses thereby increasing net income, and if they invest heavily, then a lot?

Sep 20, 2018

Yup I agree with that, but I think this question is looking at it from a DCF valuation perspective, if looking at it from a multiples POV, metrics like EBITDA and EPS would increase because you're removing it from your I/S.

Thanks for broadening the scope of discussion though, now I realise there are more ways of looking at it. Sb'ed

    • 1
Sep 21, 2018

I always reverse capitalized R&D when I see it since it is nothing more than (in my opinion unfair) opex normalization.

But there are multiple ways of looking at this including what is stated above since it increases EBITDA, but it will not always increase EPS, since it has to be ammortized at some point.

It also depends on how you use Capex in your valuation, because in any case it will show up as capex on intangible fixed assets on the CF statement.

IRR wise it could work wonders if you capitalize R&D, e.g. if you capitalize 5m R&D and ammortize over 5 years

Sep 20, 2018

Could you talk more about normalising OPEX?

And what do you mean by how you use CAPEX in your valuation?

Sep 21, 2018

I don't know what you want me to say about normalizing opex, do you have more specific questions?

I use capex in my cash flow calculations to determine IRR

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Sep 21, 2018

I think the company would lose value and my reasoning for it is this.

Currently, you expense R&D through the balance sheet which increases the tax shield by (t)*R&D expense. Lets assume 100 R&D expense this means your tax shield is 20 assuming a 20% tax rate. Based on time value of money I get all of that benefit today.

Lets now say that I can't expense it and I have to amortize it. Instead of 100 expense in this year now I charge 20 (100/5) to my P&L assuming a 5 year amortization using straight line. Now my tax shield if only 4 (20%*20) the remainder of which will be discounted and we all know money today is worth more than tomorrow.

    • 1
Sep 21, 2018


Dec 12, 2018

As far as I can tell (estimating a one-time R&D expense of 100 turning into a 5 year amortisable expense and a 50% tax rate) this would be the change in valuation going from an expense method to a capitalisation method of accounting:
1. The original expense of 100 gets added back on in the income statement, increasing EBIT by 100
2. But we amortise 20 of the R&D, meaning (same as depreciation) we now have EBIT down by 20. Overall, EBIT is up by 80.
3. Going into our DCF, multiplying the EBIT by (1-t) we now have that our NOPAT is up by 40 from where it otherwise would have been.
4. To get down to our unlevered free cash flow, we add back non-cash D&A expense, therefore we add back the 20.
5. At the moment, we have year 1 UFCF up by 60 from where it otherwise would have been with non-amortisable R&D.
6. However, each year after this we will see further amortisation of the 20 R&D expense, meaning EBIT is down by 20, NOPAT down by 10, but adding back the D&A expense of 20 we still have UFCF up by 10 for the remaining 4 years of the amortisation period.

Someone please correct me if I am wrong, but I am usually led to believe that once a non-cash expense becomes tax-deductible it actually increases UFCF leading to a higher DCF valuation.

Effectively, it is figuring out whether, with 50% tax, a year 1 UFCF of minus 50 (100(1-t)) is worse/better than UFCF of +10 (20(1-t) + 20) for the amortisation period, which would always seem to be the case.

    • 1
Dec 12, 2018

1) It says accounting rule - not tax rule. So this probably has no impact on your tax situation or cash flow.

2) Purely from an accounting perspective, if the firm is heavily investing in R&D right now, capitalizing it would remove a big expense from IS and boost NET INCOME & EBITDA, therefore probably adjusting your valuation.

BUT, if the firm invests heavily in R&D all the time, if it's amortized, then the annual amortization would roughly approximate the capitalized expenditure, so not a big impact net-net

Dec 12, 2018

The accounting rule of amortising (recognising it in the P&L over a number of years) vs expensing it all in the year of recognition is not a tax rule, yes. However when looking at a company's valuation change due to the new accounting rule, the EBIT of the company will change which is affected by tax and thus goes on to affect cash flow. Maybe we disagree here.

I agree with your last point, but the question still remains will valuation go up, down or remain constant, no matter the magnitude of change.

All in all a pretty interesting interview question.

Dec 12, 2018

If the company is valued off a multiple, it goes up.... That is obvious

Most Helpful
Dec 13, 2018

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.


    • 3
Dec 12, 2018

Yes this is right, I forgot to add back the 100 R&D expense which would be considered as a capex in the new accounting rule in my answer

Dec 13, 2018