Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 47

EVA® NOPAT and EVA® Capital: Operating Approach You are provided with the following financial statement information from Astro, Inc. for its most recent fiscal year.

Statement of Financial Position (Balance Sheet) End of Year(000s)
Assets
Cash	$35
Net Accounts Receivable (A/R)	190
Inventory	190
Other current assets	95
Total current assets	$510
Property, plant, and equipment (net)	605
Other long-term assets	120
Total assets	$1,235
Liabilities and Stockholders’ Equity
Short-term debt (@10%)	$100
Accounts payable	150
Income taxes payable	20
Other current liabilities	200
Total current liabilities	$470
Long-term debt (8%)	150
Other long-term liabilities	120
Total liabilities	$ 740
Deferred income taxes	70
Common equity	425
Total liabilities and shareholders’ equity	$1,235

The statement of income for the company for the year just ended is as follows:

Statement of Income Most Recent Year (000s)
Net sales	$2,000
Cost of goods sold (CGS)	1,670
Gross margin	330
Less: SG&A costs	185
Depreciation	35
Other operating expenses	50
Total expenses	270
Net operating profit	60
Less: Interest expense	22
Plus: Other income	12
Income before tax	50
Less: Income tax (@ 40%)	20
Net profit after tax	$ 30

Assume a weighted-average cost of capital (WACC) of 10.7% and an income tax rate of 40%.

Required

1. Prepare, using the operating approach, an estimate of EVA® NOPAT. In addition to the above data, you discovered the following: increase during the year of the LIFO reserve, $2; imputed interest expense on noncapitalized leases, $4; and increase in deferred tax liability during the year, $5. (Hint: The correct answer is $53; the amount of cash taxes paid on operating profit during the year is $25.) What is the rationale for the various adjustments you made to the company’s reported income statement?

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2. Prepare, using the operating approach, an estimate of EVA® capital. (Hint: The correct answer is $925.) In addition to the above information, you note the following: end-of-year value of the LIFO reserve, $10; and present value of noncapitalized leases, $50. What is the rationale for the adjustments you made to reported balance sheet amounts in order to estimate EVA® capital?

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3. Given the company’s WACC, what is the estimated EVA® for the year? How do you interpret this figure?

Step 1 of 3

Students should understand that EVA® is an approximation of an entity's true (i.e., "economic") profits for a period. This measure of profitability is defined as the difference between the entity's NOPAT (net operating profit after tax) and an imputed capital charge. NOPAT is supposed to approximate the entity's actual cash yield generated for investors from recurring business activities during the period. The amount of capital employed is supposed to represent the cash that investors have put at risk in the firm, and upon which they expect an appropriate return. To estimate both NOPAT and the amount of capital for a period, the analyst begins with reported financial statement amounts and then makes adjustments. These adjustments, in the parlance of EVA®, are collectively referred to as "equity equivalent adjustments."

?The Operating Approach to NOPAT estimation starts by deducting operating expenses—including depreciation--from sales. Next, equity-equivalent (EE) reserve adjustments are made. Interest expense, because it is a financing charge, is ignored, but other (operating) income is added to get pretax economic profits, or Net Operating Profit Before Tax (NOPBT). Finally, an estimate of cash tax expense on these operating profits is deducted, resulting in NOPAT. Under the Operating Approach, EVA capital is defined as the sum of net assets less non-interest-bearing current liabilities (NIBCLS).

?1.?EVA® NOPAT—Operating Approach (see next page):

Net Sales	?	?	$2,000
Less: CGS	?	?	$1,670
Gross Margin		?	$330
Less: S,G,& A Expenses		?	$185
Less: Depreciation Expense		?	$35
Less: Other (cash) operating expenses			$50
?	?	?	$60
Adjustments:		?	?
Increase in LIFO reserve (1)		?	$2
Imputed Interest--Non-capitalized leases (2)			$4
Net Operating Profit		?	$66
Plus: Other Operating Income	?	?	$12
NOPBT	?	?	$78
Less: Cash taxes on net operating profit:			?
Reported Tax Expense		$20	?
Less: Increase in Deferred Tax (3)		$5	?
Plus: Tax Savings (foregone) on Interest (4)		$10	$25
NOPAT	?	?	$53
?	?	?	?
Income Tax Savings on Interest Expense (@40%):			?
Reported interest expense		?	$22
Imputed interest on non-cap. Leases			$4
Total interest (financing) expense			$26

Rationale for EE Adjustments made:

(1)?LIFO Reserve: brings into earnings the current-period effect of unrealized gain attributable to holding inventory during period of rising prices

(2)Imputed Interest--Non-Capitalized Leases: Puts Operating and Capital Leases on equal footing in terms of effects on EVA NOPAT. In both cases, we want to remove the interest cost associated with leases because this is a financing, not operating, expense.

(3) Increase in Deferred Taxes: If the Deferred Tax liability increases during a period, it implies that cash taxes paid during the year<reported tax expense (and vice-versa).

(4) Tax Savings on Interest: If Interest Expense is eliminated from the determination of NOPAT, then we logically need to eliminate the tax shield (tax savings) from NOPAT income as well.