The total SI asset includes both "brick and mortar" from the investment plus the "financing cost" of that investment. The entire SI asset is then segregated from net assets in a capital suspense account so that it does not get charged against EP. (As mentioned before, the capital charge on the SI asset in the capital suspense account would be capitalized into the SI asset).

Illustration

To illustrate this adjustment, we provide the following example. A project requiring a $20 investment in Year 1 and an $8 additional investment in Year 2 will generate zero income the first year and income that grows to $8 per year by Year 5.<

This project creates value. Negative early year EP/EVA is more than covered by positive EP after Year 3. If the $8 per year NOPAT persists into the future, the NPV of this project is nearly $40. The problem, of course, is how to disguise the $3.8 penalty of the first two years while preserving accountability for all $28 invested. The Option 3 adjustment achieving this trade off is illustrated as follows.

Here, we invest $20 in Year 1, the year with no income. We should be charged $2 for that investment. Our plan, however, is to place the whole SI asset into a capital suspense account for the first two years. Thus in Year 1, instead of taking the $2 capital charge against EP in the current period, that charge is capitalized into the SI asset for Year 2. In Year 2, we invest another $8, but instead of a total SI asset being $28, we now have a SI asset of $30. This includes the nominal $28 investment plus the $2 carrying cost of the prior year’s $20 investment. Now, Year 2 is also a year where the SI asset is in capital suspense, so we capitalize that year’s SI asset charge of $3 as well. This will bring the total SI asset up to $33.

Finally, in Year 3, the SI asset is not longer in the capital suspense account and EVA includes the charge on the full SI asset, including the cumulative capitalized charges from the early years (this example is simplified by ignoring amortization). Thus, this example shows no negative EP in the early years, but EP in later years bearing the full cost of the investment.

Policies

A key to making this treatment work is the discipline to bring the SI asset into the business unit's capital base according to the schedule put forth in the original project proposal, as approved. Delaying the onset of capital with further capitalization of the capital charge is acceptable only if that delay is also approved (as a separate project, so to speak). Otherwise, managers should not have the discretion to indefinitely put off "paying the bill."Managers should, however, have the discretion to "pay early" by having project capital come into the business unit capital base sooner than originally projected.

Management may go one step further in adding discipline to this process by capitalizing the planned capital charge (as opposed to the actual capital charge that would arise from actual expenditures, which may differ from projected costs). Any income variances from budget would create an EP impact on the whole business unit, positive or negative depending on how the project is managed. If the project was well designed and well executed, variance from projections should be small enough to avoid any significant effect on business unit EP.

Benefits

This treatment is analogous to a credit card balance being allowed to grow as it rolls forward instead of being paid down in the current billing cycle. It leaves managers relatively EP neutral during the ramp-up phase. But it also maintains accountability for the ultimate level of investment since that investment and it’s timing will affect EP as the SI asset eventually comes into business unit capital. If management over-invests, business unit EP will be lower than otherwise it could be. Also, unlike Option 2, the effectiveness of this treatment does not rely on being able to segregate the impact of the investment from results of the ongoing business. Project "reviews," which are next to impossible for most projects underway after several years, will still be useful for managerial purposes, but accountability for the project will be built into the overall results for the business.

Drawback

The drawback to this treatment is the requirement to track and explain the capital suspense account. Any assets in this account will be accumulating capital charges on those assets, much like capitalized interest accumulates on CIP. If SI assets remain in this account for a pre-specified period, as is usually recommended, then this time must be tracked and communicated as well.

Various thresholds or decision rules must be developed to guide managers as to what kind of investment would be subject to this treatment. Usual guidelines include a certain percentage of existing capital or a certain projected negative impact on EP absent any adjustment.