Hodak - Measuring EP/EVA

Option 1b: Accrued Operating Tax with Implied Tax Assets

Unfortunately, the above statement that all three cost profiles are equivalent is not quite true. There will always be a lag between the time an expense is capitalized in an EP report and the time the tax benefit is actually realized in the form of cash savings in taxes. Theoretically, this capitalized tax benefit should be treated as a tax asset, in other words as part of capital, until the tax benefit is actually realized.
Table 1: EP (improperly) failing to reflect deferred tax asset

If, say, eight months elapse from the time a $4,000 tax benefit is accrued until the deduction actually saves cash for the business, then EP should reflect eight months worth of capital charge on that $4,000. Since this lag can last a year or more, significant tax benefits can make EP look better than it should, perhaps making marginally negative EVA projects look positive.

Therefore, to convert a capitalized expense from a pre-tax to an after-tax charge, one more step is technically required. The tax benefit should be capitalized as a deferred tax asset. This would reflect the delay between the time the $4,000 tax benefit is recorded (as $6,000 investment when $10,000 has actually been spent) and the time the tax savings would actually benefit NOPAT (presumably at the end of the tax year).

Table 2: Deferred tax asset arising from capitalized expense

This "Tax asset" adjustment has some salient drawbacks. The adjustment is rather complicated. Its effect will never be very large; thus it would only improve decisions on marginal projects. Valuations based on EP without this adjustment will not exactly equal discounted free cash flow, but the difference (i.e., the discounted cash value of waiting for the tax asset to be realized) is likely to be very small against the scale of a project's overall value.