Hodak - Measuring EP/EVA

Option 1: Accrued Operating Tax

The corporate tax provision has been reduced by the effect of various expenses, certain of which may have been selected for different treatment under EVA reporting. For example, restructuring charges are usually capitalized under EVA. Since the tax benefit of restructuring is buried in the tax provision, it matters whether we capitalize restructuring charges on a pre-tax or after-tax basis. Capitalizing pre-tax restructuring charges spreads out restructuring costs into the future while their tax benefit is recognized in the year of the charge. This can actually reward restructuring in the year a charge is taken. For example, assume we undertake a $10,000 restructuring and capitalize the charge. At a 40 percent tax rate, the EVA impact would be:

                                                                     Year 1                     Year 2+
Capitalized restructuring charge           $10,000                    $10,000

Capital charge (at 10%)                           ($1,000)                    ($1,000)

Tax benefit of restructuring charge        $4,000                              $0

(buried within the tax provision)

EP impact                                                   $3,000                    ($1,000)

In subsequent years you will need to earn returns to justify the pre-tax charge, but in the first year you are rewarded for simply taking the charge. That is why restructuring charges should be capitalized after tax and the income adjusted to reflect the tax benefit being added back to taxes:

                                                                     Year 1                     Year 2+

Cap'd restructuring charge (after-tax)   $6,000                      $6,000

Capital charge (at 10%)                              ($600)                      ($600)

Tax benefit of restructuring charge        $4,000                             $0

Adjustment to Income                             ($4,000)                              -

(or, add-back to taxes)

EP impact                                                    ($600)                      ($600)

Note that this "Adjustment to Income" merely completes the adjustment to capital being made on a pre-tax basis. This method is equivalent to capitalizing the tax benefit along with the charge.

This "completion of adjustment" to taxes is also required when only income and not capital is affected. The clearest example is our "interest expense" adjustment to income, whereby the level of interest expense (which is driven by financing considerations) would not affect NOPAT. As part of that adjustment, the cost of debt was built into the weighted-average cost of capital on an after-tax basis. The resulting after-tax cost of capital applies the tax benefit of interest to the entire capital base. That is why we add back "interest expense" to income on an after tax basis, i.e., subtracting the tax benefit of interest from income when we add interest expense back to income. Subtracting the tax benefit completes the adjustment. Therefore, subtracting the tax benefit of the interest expense from income (or adding that benefit to the tax provision, which would have the same effect) avoids double counting the tax benefit of interest.

Similarly, you may choose to capitalize and amortize certain expenses, as you might do with R&D under EVA, to eliminate a bias against appropriate spending. However, when this adjustment is made on a pre-tax basis it leaves the tax benefit of those adjustments in income, (just as in the restructuring charge example above). Such a treatment would shift the bias toward overspending on activities being capitalized. Just as with the restructuring example, the current year tax benefit of a tax-deductible expense is generally higher than its adjusted total "cost of investment." For example, lets assume that the expense is $10,000 and that it should be capitalized and amortized over five years. In the first year:

Amortization charge                ($2,000) ($10,000 divided by five years)

Capital balance                        $10,000 (beginning of the year capital balance)

Capital charge                          ($1,000) (assuming 10 percent cost of capital)

EP "cost of investment"        ($3,000)

This indicates a total "cost of investment" of $3,000 in the first year. Thats better than a $10,000 expense in terms of encouraging spending on a project whose benefits take time to materialize. But it gets better. The above example capitalizes the expense on a pre-tax basis and ignores the tax benefit that this expense would generate. At a 40 percent tax rate, the tax benefit of a $10,000 expense is $4,000. Thus, the net EVA impact of this expense is not a cost at all, but a profit of $1,000. This makes the expense look EVA positive in the first year, regardless of the economic consequences of that expense. Figure 1 shows the "cost of investment profile" (amortization plus capital charge on the unamortized balance) over all five years. Management is rewarded in the first year of the project for the mere act of flowing cash out the door.

To remedy the potential behavioral problems arising from the immediate rewards of spending, the adjustment should be completed, so to speak, by capitalizing and amortizing the expense on an after-tax basis:

Amortization charge            ($1,200) ($2,000 amortization less 40 percent tax)

Capital balance                      $6,000 ($10,000 capitalized expense, after 40% tax)

Capital charge                         ($600) (assuming 10 percent cost of capital)

EP "cost of investment"      ($1,800)

Thus, instead of a first year "profit" of $1,000, the first year cost would be $1,800. The five-year "cost of investment profile" in Figure 2 shows a more uniform pattern of cost. This encourages spending on projects that yield returns over time that are greater than this cost.