As
a final exercise, consider the effect of converting
operating leases to debt on the return on
capital in table 9. To make this computation,
we first estimate the present value of operating
leases in 2005, the most recent financial
year, using the same estimation process we
used in 2006.24
The debt value of operating leases that we
obtain from this computation was $2,335 million.
The
after-tax return on capital decreases from
24.52%, on a pre-adjustment basis, to 14.21%,
on a post adjustment basis. The cost of capital
is also affected, since the debt ratio is
a function of whether we categorize leases
as debt. The resulting excess return shows
the real impact of the conversion, dropping
from 15.09% before the conversion to 5.38%
after the conversion.
One-time,
Restructuring and Other Charges
Extraordinary
and one-time charges and income often skew
both earnings and invested capital measures
at firms. As a general rule, the income that
is used to compute returns on equity and capital
should reflect continuing operations and should
not include any items that are one-time or
extraordinary. Extraordinary charges also
reduce invested capital and throw off return
on capital computations. In fact, firms with
mediocre investments can report healthy returns
on capital by writing off significant amounts
of the capital over time. In this section,
we will begin by categorizing one-time charges
for earnings purposes and then consider the
capital adjustments that may needed as a consequence.
Adjusting
Earnings for Extraordinary Items
If
all extraordinary items were truly extraordinary
and labeled as such, the adjustment to earnings
would be trivial. We would eliminate these
items from consideration and consider the
earnings before them. In practice, though,
there are four types of extraordinary items:
-
One-time expenses or income
that is truly one time: A large restructuring
charge that has occurred only once in the
last 10 years would be a good example. These
expenses can be backed out of the analysis
and the operating and net income calculated
without them.
-
Expenses and income that
do not occur every year but seem to recur
at regular intervals: Consider, for instance,
a firm that has taken a restructuring charge
every 3 years for the last 12 years. While
not conclusive, this would suggest that
the extraordinary expenses are really ordinary
expenses that are being bundled by the firm
and taken once every three years. Ignoring
such an expense would be dangerous because
the expected operating income in future
years would be overstated. What would make
sense would be to take the expense and spread
it out on an annual basis. Thus, if the
restructuring expense for every 3 years
has amounted to $1.5 billion, on average,
the operating income for the current year
should be reduced by $0.5 billion to reflect
the annual charge due to this expense.
-
Expenses and income that
recur every year but with considerable volatility:
The best way to deal with such items is
to normalize them by averaging the expenses
across time and reducing this year's income
by this amount.
-
Items that recur every
year but are positive in some years and
negative in others: Consider, for instance,
the effect of foreign currency translations
on income. For a firm in the United States,
the effect may be negative in years in which
the dollar gets stronger and positive in
years in which the dollars gets weaker.
The most prudent thing to do with these
expenses would be to ignore them. This is
because income gains or losses from exchange
rate movements are likely to reverse themselves
over time, and making them part of permanent
income can yield misleading estimates of
value.
To
differentiate among these items requires that
you have access to a firm's financial history.
For young firms, this may not be available,
making it more difficult to draw the line
between expenses that should be ignored, expenses
that should be normalized and expenses that
should be considered in full.
24
We are staying true to the notion that return
on capital has to be computed based upon capital
invested at the start of the year and not
the end of the year. We used the lease commitments
in the financial statements of the previous
year to make this computation.
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