Illustration
1: Capitalizing R&D expenses: Amgen in May
2006
Amgen
is a biotechnology firm. Like most firms in
this business, it has a substantial amount
of R&D expenses and we will attempt to capitalize
it in this section. The first step in this
conversion is determining an amortizable life
for R & D expenses. How long will it take,
on an expected basis, for research to pay
off at Amgen? Given the length of the approval
process for new drugs by the Food and Drugs
Administration, we will assume that the amortizable
life is 10 years.
The
second step in the analysis is collecting
research and development expenses from prior
years, with the number of years of historical
data being a function of the amortizable life.
Table 4 provides this information for the
firm.
Amgen's
growth over this time period is reflected
in its R&D expenses that have increased more
than six-fold over 10 years.
The
portion of the expenses in prior years that
would have been amortized already and the
amortization this year from each of these
expenses is considered. To make estimation
simpler, these expenses are amortized linearly
over time; with a 10-year life, 10% is amortized
each year. This allows us to estimate the
value of the research asset created at each
of these firms and the amortization of R&D
expenses in the current year. The procedure
is illustrated in table 5:
Note
that none of the current year's expenditure
has been amortized because it is assumed to
have occurred at the time of the analysis,
but also note that 50% of the expense from
5 years ago has been amortized.14
The sum of the dollar values of unamortized
R&D from prior years is $10.113 billion. This
can be viewed as the value of Amgen's research
asset and would be also added to the book
value of equity for computing return on equity
and capital. The sum of the amortization in
the current year for prior year expenses is
$1.149 billion.
14
This follows directly from the end of the
year convention that we have adopted for the
cash flows, where all the cash flows are assumed
to occur at the end of each period. If we
used a mid-year convention for cash flows,
it would make sense to amortize half the current
year's expenditure.
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