Hodak - Measuring EP/EVA

Option 2: Exclude All Cash and Cash Equivalents

Cash is subtracted from net assets, and its associated interest income is subtracted from income. This treatment is appropriate for business units that have no control over treasury functions. In contrast to the prior treatment, this provides a strong incentive to maximize cash flow through the collection of receivables, disposition of unprofitable assets, and the extension of payment times on non-interest-bearing liabilities. All the business has to do is generate cash, then the cash belongs to somebody else. NOPAT goes up and capital does not.

One potential measurement problem is the identification of "associated interest income," that is, the income attributable solely to cash and cash equivalents. The business unit may have several sources of interest income, only some attributable to cash. If this income is difficult or costly to identify and track, then the business unit should consider an "all-or-nothing" treatment for its sources of interest income. In other words, if cash is excluded from net assets, then so should all other sources of interest income; if other sources of interest income are allowed to remain in net assets, then cash should be left in, too. This determination should rest on the relative significance of these various sources of interest income.

While this treatment effectively gives the business unit a "free ride" on its cash balances, as if no return were required from investors, this should poses no problem. As long as the individuals directly responsible for cash management (i.e., Treasury/Corporate) are under the right incentives, then the cash will be managed appropriately.