A startup software firm, Hidden Code Co., budgets R&D expenditures of $120 (million) for the foreseeable future.

Each dollar of R&D expenditure is expected to generate $2 dollars of revenue for 3 full years following the expenditure, then zero revenues thereafter.

Additional information: The company’s current level of net operating assets is $90 million. There is no outstanding debt. Operating expenses (other than software R&D costs) are expected to be 75 percent of sales.

1. Calculate Hidden Widgets’ expected operating income and RNOA for the next 3 years under the assumption that software R&D costs are expensed immediately.

2. Calculate RNOA for the next 3 years under the assumption that software costs are capitalized and amortized straight line over the 3 years.

3. Assume that you are a manager for Hidden Code Co. and your compensation package calls for bonuses to be paid in 3 years.

Identify the method of accounting for software R&D you would prefer if bonuses were based on:

i) The level of income?

ii) A fixed multiple of profitability?

Explain your answers to receive credit.