Hodak - Measuring EP/EVA

Option 2 (Corporate): Cash Operating Taxes

This treatment takes changes in net deferred tax liabilities (or assets) and adds them back to income (or subtracts them from taxes---same effect) and adds the net deferred tax liability to net assets (or the reverse treatment for deferred tax assets). If there is a valuation allowance reducing the deferred tax assets, that allowance would also be added to capital and any increase (decrease) in that allowance added (subtracted) to income. The effect of this adjustment is to reflect taxes in EP on a cash basis. Only taxes actually paid would affect EBIT while taxes that are deferred, i.e., the cash not paid to the government and still in the business, remain in Capital. For example:

   Income before interest* and taxes       $800

Tax provision*                                    $300

+ Change in deferred tax liability      $100

   Cash taxes                                        $200

   EP                                                    $600

* Interest is assumed to have been added back to income after-tax; or, if interest has been added back pre-tax, then the tax provision is presumed to have been adjusted by the add-back of the tax benefit of interest.

If a company grows its deferred tax liabilities, EBIT would be higher than it would be absent this adjustment, but so would be Capital---and the requirement to earn returns on that additional Capital. However, as deferred taxes "unwind," i.e., come due because the asset is aging or has been sold, EBIT will be lower than it would have been absent the adjustment while Capital appears to decline.

The rationale for cash taxes is that management will pay much closer attention to taxes if the cash impact of tax payment is reflected in the period-to-period accounting of Income. While that is certainly true, there are some distinct drawbacks to this treatment. The first is that management may be making value added expenditures that are being appropriately capitalized for a while, then decide that the investment opportunity has temporarily dried up. The moment management holds back on further such expenditures, the tax benefits disappear and EP will automatically drop. Thus, managers would be penalized for making the value-driven decision of withholding spending on poor investments. The second drawback is that management may have grown a line of business for a while until it reaches a mature stage where further growth becomes difficult. By then, the deferred tax liabilities of that business have also grown to a substantial amount and the shareholders have benefited from the deferral of tax payments. However, a new management is faced with the value-added disposition of the line of business and, if they sell it, the tax deferrals unwind. Despite significant value creation from the sale, EP would inevitably take a large hit.

Thus, while cash operating taxes provides the highest degree of sensitivity to tax consequences of business activities, it can only provide reasonable matching of revenues, expenses, and capital charges in a business environment unlikely to see any slowdown in its growth or sale of assets.

Finally, if we truly revert to cash taxes, this would imply undoing the prior treatment (Option 1) as it pertains to capitalized charges and expenses. Recall from the examples in Option 1 that if we capitalize an expense that has a current period tax benefit, then treating that tax benefit on a cash basis will make almost any such expense "EP positive" in the year it is incurred. We would be automatically rewarding spending, per se. While management may be penalized in later years for such expenses, the day of reckoning can be delayed for many years as long as the expense keeps growing. Thus, even when choosing cash operating taxes, it is advisable to capitalize (and, if appropriate, amortize) the tax benefit of capitalized charges.