Question

A. A firm's value-to-book and market-to-book ratios may differ from one for a number of reasons. Discuss how a successful internally funded research and development program would create a situation where the value-to-book and market-to-book ratios differ from one.

Answer 1

As per my understanding from the question, you want a scenario where the company Market Value to Book Ratio differs from 1 (P/B != 1). Below is the scenario/situation:

Company R&D is an Intangible asset which conservative accounting principles don't account for.

If the Research wing is working on several innovations and have patents, the market value of the company rises due to the future prospects (promised returns) of the endeavour, but the Book value doesn't account for it (due to conventional accounting), leading to P/B ratio > 1

On another hand, in case of bankruptcy, the earning power of firm plunges and hence leading P/B <1.

investment in internally funded Research & development should be encouraged by the companies by decreasing its book value. Because Research & Development can build unusual production revenues for a company like patents royalty. Market participants may increase the share price due to Research and Development practices, which results in the difference between market and book value.