440  Nonoperating Items, Provisions, and Reserves equivalent and therefore is not netted against operating assets to determine invested capital. Since nonoperating income and expenses do not flow through free cash flow, the restructuring expense must be valued separately on a cash basis. To convert accrual-based restructuring expenses to cash, start with the restructur- ing expense, and subtract the increase in the restructuring reserve. This leads to a cash-based restructuring provision of $0 in year 2 and $30 million in year 3 (free cash flow and its reconciliation are presented in Exhibit 21.9). The pres- ent value of the nonoperating cash flow stream equals $22.5 million, which must be deducted from the value of operations to determine equity value, as shown in Exhibit 21.10. Income-Smoothing Provisions  Except for limited circumstances, provisions to smooth earnings are not allowed under International Financial Report- ing Standards or U.S. Generally Accepted Accounting Principles (GAAP). To EXHIBIT 21.9  Free Cash Flow with Provisions and Reserves $ million Year 1 Year 2 Year 3 Year 4 NOPAT 142.3 172.3 62.3 240.0 Depreciation 7.7 7.7 7.7 – Gross cash flow 150.0 180.0 70.0 240.0 Investment in invested capital (120.0) (120.0) (120.0) 960.0 Present value at 10% = 858.9 Free cash flow 30.0 60.0 (50.0) 1,200.0 Reconciliation of free cash flow Provision for restructuring – 30.0 – – (Increase) decrease in restructuring reserve – (30.0) 30.0 – Present value at 10% = 22.5 Cash-based restructuring provision – – 30.0 – Decommissioning reserve, accretion 15.0 16.5 18.2 – (Increase) decrease in decommissioning reserve (15.0) (16.5) 181.8 – Dividends 40.0 70.0 – 1,120.0 Equity repurchases (issues) (10.0) (10.0) (280.0) 80.0 Free cash flow 30.0 60.0 (50.0) 1,200.0 EXHIBIT 21.10  Enterprise DCF with Provisions and Reserves $ million Valuation Methodology Value of operations 858.9 Summation of discounted cash flow Value of restructuring provision (22.5) Present value at 10% (debt equivalent) Reserve for plant decommissioning (150.3) Reported on balance sheet (debt equivalent) Equity value 686.1 Closing Thoughts  441 ­prevent earnings manipulation or even the perception of it, many companies use a third party to estimate key provisions. In some situations, companies can use provisions to smooth earnings. For instance, defense contractors will use income smoothing when they believe a long-term contract’s value has changed. In Exhibit 21.6, our hypothetical company was able to show a smooth growth in reported EBITA and net income by using a smoothing provision. We choose a straightforward title for the account, “Income-smoothing pro- vision,” but actual companies typically use subtler wording, such as “Other provisions.” For our hypothetical company, a provision was recorded in years 1 and 2 and was reversed in year 3. By using an income-smoothing provision, the company hid its year 3 decline in operating performance (operating costs rose from 75 percent to 85 percent of sales). To evaluate the company’s performance properly, eliminate any income- smoothing provisions. Do this by adding the income-smoothing provision back to reported EBITA (essentially undoing the income-smoothing provi- sion). In this way, we are converting the provision to cash, rather than ac- counting for it as an accrual, and subsequently need to treat the reserve as an equity equivalent (using a process identical to the one for deferred taxes). Since income-smoothing provisions are entirely noncash, they don’t affect free cash flow or valuation. Provisions and Taxes In most situations, provisions are tax deductible only when cash is disbursed, not when the provision is reported. Thus, most provisions will give rise to deferred-tax assets. For example, a $30 million noncash restructuring charge would lead to a $30 million restructuring reserve. If the restructuring charge is tax deductible on the GAAP income statement, retained earnings would drop by only $21 million (assuming a 30 percent tax rate). Since the increase in the restructuring reserve does not match the drop in retained earnings, the balance sheet will not balance. To eliminate the difference, a deferred-tax asset is recognized for $9 million. For operating-related provisions, we recommend using cash, rather than accrual taxes. For nonoperating provisions, estimate the tax impact of the cor- responding provision. Do not use book values, as they reflect past accounting and not necessarily future cash flow. For an in-depth discussion of deferred taxes, see Chapter 20. Closing Thoughts The accounting definition of nonoperating expense is narrow and limited to interest expense and a few other items. Therefore, the accounting definition of operating profits will inappropriately include many one-time and other 442  Nonoperating Items, Provisions, and Reserves ­nonoperating items. Always start your financial analysis by separating operat- ing from nonoperating items on the income statement. This will create a better picture of the company’s performance and its potential for generating future cash flow. In some cases, the proper classification of a particular expense will be unclear. But don’t let this distract you from the task at hand. A proper valuation will not depend on how the item is treated, as long as you include it somewhere and treat it consistently.