438  Nonoperating Items, Provisions, and Reserves the reserve is related to the ongoing operations, the reserve should be treated the same way as other non-interest-bearing liabilities (e.g., accounts payable and wages payable). Specifically, the provision should be deducted from rev- enues to determine EBITA. The corresponding reserve ($100 million) should be netted against operating assets ($723.1 million) to measure invested capital ($623.1 million). Since the provision and reserve are treated as operating items, they appear as part of free cash flow and should not be valued separately. Long-Term Operating Provisions  Sometimes, when a company decommis- sions a plant, it must pay for cleanup and other costs. Assume our hypotheti- cal company owns a plant that will operate for ten years and requires $200 million in decommissioning costs. Rather than expense the cash outflow in a lump sum at the time of decommissioning, a company will instead record the present value of the cost as both an asset and a liability at the time of invest- ment.3 In this case, the ten-year present value of $200 million at 10 percent equals $77.1 million.4 It’s as if the company borrowed $77.1 million and holds the money in restricted cash to fund the future decommissioning outlay. Once the decommissioning asset and reserve are recognized, the decom- missioning asset is depreciated (similar to the way restricted cash is paid into an outside fund set aside for cleanup), and the reserve is grown (as if the debt accumulates unpaid interest charges). As a result, the decommissioning cost is recognized over the life of the asset, instead of a lump sum at closing. If the decommissioning costs are substantial, as with a nuclear power plant or a mine, the costs will be presented in the company’s footnotes. We show a sample note in Exhibit 21.8. In Panel A of Exhibit 21.8, the decommission- ing asset declines by $7.7 million each year. This expense is computed using straight-line depreciation on the original decommissioning asset. In Panel B, the decommissioning reserve grows each year by an ever-increasing amount, computed at 10 percent of the prior year’s ending reserve. This expense, which mimics interest, is known as accretion. In year 1, the current-year reserve of $150.3 million grows by $15.0 million in accretion. The income statement pre- sented in Exhibit 21.6 reports both depreciation and accretion as operating items, often embedded within depreciation and operating costs, respectively. To estimate NOPAT, invested capital, ROIC, and FCF, apply the guiding principles presented in Chapter 11. When reorganizing the income statement, 3 In the United States, asset retirement obligations (AROs) are governed by SFAS 143. Entities covered by IFRS use IAS 37, where the AROs are called “provisions.” 4 In Exhibit 21.6, the current year represents the seventh year of the plant’s expected ten-year life. Con- sequently, the decommissioning asset and the decommissioning reserve no longer equal their initial value of $77.1 million. Instead, the decommissioning asset has been depreciated seven years to $23.1 million, using straight-line depreciation. Conversely, the decommission reserve grows annually at the discount rate. As a result, the current year reserve equals $77.1 million × (1.10)7, which equals $150.3 million. Provisions and Their Corresponding Reserves  439 treat depreciation as an operating item. Conversely, since accretion mimics interest, do not include accretion in NOPAT; instead, include it in the reconcili- ation to net income, next to interest expense. NOPAT and the reconciliation to net income are computed in the top portion of Exhibit 21.7. To reorganize the balance sheet, classify the decommissioning asset (which is comparable to restricted cash) as part of invested capital and the reserve as a debt equivalent. Invested capital and its reconciliation are presented in the bottom half of Ex- hibit 21.7. To compute free cash flow, start with NOPAT, add back depreciation of the decommissioning asset (since it is noncash), and subtract investments in invested capital. Free cash flow is presented in Exhibit 21.9. When you treat the plant closure reserve as a debt equivalent, the interest expense and reserve drawdown will not flow through free cash flow. There- fore, subtract the current reported reserve ($150.3 million as of today) from the value of operations ($858.9 million) to determine equity value. The value of operations, which includes this and other deductions, is converted into equity value in Exhibit 21.10. One-Time Restructuring Provisions  When management decides to restruc- ture a company, it will often recognize certain future expenses (e.g., severance payments) immediately. We recommend treating one-time provisions as non- operating and treating the corresponding reserve as a debt equivalent. In year 2, our hypothetical company declared a $30 million restructuring provision, which will be paid in year 3 (see Exhibit 21.6). Since the restructuring is non- operating, it is not deducted from revenues to determine NOPAT. Rather, it is included in the reconciliation to net income (see Exhibit 21.7). Because we plan to value the provision on a cash basis, the noncash reserve is treated as a debt EXHIBIT 21.8  Provisions and Reserves in the Notes $ million Today Year 1 Year 2 Year 3 Panel A: Change in the asset account Decommissioning asset, starting 30.8 23.1 15.4 7.7 Depreciation (7.7) (7.7) (7.7) (7.7) Decommissioning asset, ending 23.1 15.4 7.7 – Panel B: Change in the liability account Decommissioning reserve, starting 136.6 150.3 165.3 181.8 Accretion expense at 10% 13.7 15.0 16.5 18.2 Payout – – – (200.0) Decommissioning reserve, ending 150.3 165.3 181.8 – Panel C: Income statement Decommissioning asset, depreciation 7.7 7.7 7.7 – Decommissioning reserve, accretion 15.0 16.5 18.2 – Decommissioning expense 22.7 24.2 25.9 –