Question

CVRX Ltd., one of the world’s largest biotechnology companies, invests considerable amounts in research and development each year. In the most recent fiscal year (2020), the R&D expense was $500 million, the net income was $1,000 million, and the book value of equity was $8,000 million. The R&D expenses for the prior 3 years are as follows: $1,200 million (2019), $900 million (2018), and $600 million (2017).

1. Would you expect the Free Cash Flows to the Firm (FCFF) of CVRX Ltd. to increase or decrease as a result of the capitalisation of the R&D expenses? Please explain briefly in the space provided below.

2. Please explain below why the capitalisation of R&D expenses changes the reinvestment rate of CVRX Ltd..

3. Assuming an amortizable life of 3 years, determine the amortization of capitalised R&D in each of the R&D years. Please type your answer below.

Amortization in 2020 = ……………………

Amortization in 2019 = ……………………

Amortization in 2018 = ……………………

Amortization in 2017 = …………………....

4. Determine the total Value of Research Asset for CRVX and the R&D amortization expense for the current year. Please type your answer below.

Value of Research Asset in 2020 = ……………………

5. Compute the Net Income, Book Value of Equity (BVE) and Return on Equity (ROE) of the firm before and after capitalising the R&D expenses. Please type your answer below.

Net Income (before capitalisation) = ……………………

Net Income (after capitalisation) = ……………………

BVE (before capitalisation) = ……………………

BVE (after capitalisation) =……………………

ROE (before capitalisation) = ……………………

ROE (after capitalisation) =……………………

6. If the WACC of CRVX Ltd. decreased to 10% after capitalising the R&D expenses, should the company continue investing in Research and Development? Please explain briefly in the space provided below.

Answer 1

a) Free Cash Flows are unaffected by the capitalization of the Expenses.

a)While the free cash flow is unaffected by capitalization of these expenses, the reinvestment rate will change. In general, if earnings and reinvestment both increase as a consequence of the capitalization of R&D or advertising expenses, the reinvestment rate will increase

Since both earnings and capital invested are both affected by capitalization, the net effects on return on equity and capital are unpredictable. If the return on equity (capital) increases after the recapitalization, it can be considered a rough indicator that the returns earned by the firm on its R&D or advertising investments is greater than its returns on traditional investments

a)vin millions

Amortization in 2020 = 867   

Amortization in 2019 = 900

Amortization in 2018 = 500

Amortization in 2017 = 200

Working

	600	900	1200	500
2017	200				200
2018	200	300			500
2019	200	300	400		900
2020		300	400	167	867

a) Value of research asset in 2020

Total R& D = 3200

Amortization = 2467

Balance (i-ii) = 733

a) WACC of CRVX Ltd. decreased to 10% after capitalising the R&D expenses, its not recommended for the company to invest on R&D .