adjusting taxes and tariffs (i.e., when implementing microeconomic reform).

The objective in this

microeconomic reform is to simplify the tax structure in a way that firms are indifferent to the
change.

MANAGEMENT COST OR ACCOUNTING COST?

In most large organizations, all the information necessary for derivation of the discounted cash
flow is available from data already collected for accounting purposes. However, if this information
is to be used directly for management decision making, then the implications of some of the
results need to be clearly understood. Accounting anomalies may make a poor manager look good
and a good manager look poora situation that is inconsistent with holding managers
accountable for cost elements under their control.

The difficulty is best illustrated with an example. Table 9.5 shows a summarized discounted cash
flow tabulation of a dozer used for a reclamation project, similar to the discounted average cost
calculation in Chapter 5 (see Table 5.6, p. 68).

Assume for a start that this project (which actually consists of only a single dozer undertaking
reclamation) is commenced and through its entire life performs exactly according to plan. Table
9.6 shows the standard accounting results that would flow from such a situation. At the start of
the project, the capital valuation of the dozer (i.e., $750,000) equated to the present value of the
expected future cash flows. In other words, the investment was yielding a 15% return.

Now consider the situation at the end of the first year. Even though everything is according to
plan, the return on assets is just 13.72%! It seems like management has failed to perform.
Similarly, for years 3 and 4, the return on assets exceeds the target 15%. It seems like
management is doing a great job when in fact they are working exactly to plan. The anomaly
comes from the method of depreciation used.

From an economic perspective, the dozer should be valued at the end of year 1 according to the
work or future value the company expects to get from it in its remaining life. The present value of
the future cash flows at the end of year 1 (expressed in year 1 valuation terms) is $590,813,
whereas the written-down value in Table 9.5 is $581,250. The straight line depreciation method is
understating the true profit by $9,563 and calling it depreciation. As a result, the accounting
profit shown on the first two lines of Table 9.6 understates the profit in the first 2 years and then
overstates the profit for the remaining 2 years.

Indeed, if this convention is used, even for projects that perform to expectations, the after-tax
profit as a percentage of sales declines throughout the machine life, while the after-tax return on
assets employed improves throughout the machine life. The accounting profession is certainly
aware of this anomaly (e.g., see Brealey and Myers [2003, p. 326]), but even if generally accepted
accounting procedures may be able to overlook it, management decision making should not.
Management guidelines based on the accounting definition of per-unit profitability bias business
decisions in favor of newer equipment. Management guidelines based on the accounting
definition of return on assets bias decisions in favor of older equipment.

For operational decision making, the criteria for asset valuation must be market based, and
internal prices and depreciation schedules must be calculated accordingly. When the same
opportunity cost of capital and all costs according to the projected investment plan are used,
depreciation throughout the life of the asset should result in written-down values that each year
balance the present value of the expected future cash flows. A company could sell its own
equipment to itself at any time, use that equipment for the intended purpose, and find thatat
that purchase price (internal asset valuation)the equipment would yield the companys
required return.

Table 9.7 sets out a cash flow similar to Table 9.5 using an economic depreciation schedule, with
accounting data similar to Table 9.6 again following (in Table 9.8).

Table 9.8 is not the same as Table 9.6 just with a new depreciation schedule. The changed
depreciation rate also affects the tax payable and ultimately the unit cost of production to balance
the cash flow.* In this table, the depreciation schedule was iteratively determined concurrently
with the discounted average cost (unit revenue) calculation. With a depreciation schedule yielding
a constant return on assets, the distorting effects of non-market-based valuations are removed,
and the bias favoring older equipment is neutralized. The second line of accounting data (in Table
9.8) shows a constant 15% return on assets consistent with the original 15% return on the original
investment.

The incorporation of market-based depreciation in operational decision making is not just a

subtlety of academic interestit forces a degree of alertness on operational personnel that is
missing when simple accounting measures are used. This alertness is vital to the management of
change.

* In most jurisdictions there is no requirement for tax-based depreciation to be the same as

depreciation for corporate finance purposes. Ordinarily a tax-based depreciation schedule will be
adopted that minimizes taxable profit early to reduce the tax payable and improve early cash flow.
Because of widely varying tax treatment of these issues around the world, the approach adopted
in this example was to keep tax-based depreciation consistent with the economic valuation of
partially worn-out equipment. As a result, the notional cost of production used in the example has
increased by 0.1% over the case set out in Table 9.5. In practice, economic depreciation would not
be used for tax purposes, and the calculated cost of production would be unchanged.
Compare, for instance, the similar, activity-based costing example from the Chapter 5 section
entitled Discounted Average Cost (p. 64) to the preceding example with and without market-
based asset management. Without marketbased asset valuation, there is no incentive to use or
even to dispose of older equipment if, by circumstance, the mine has too much equipment or
inappropriate equipment. Such a circumstance is common in many industries subject to changing
technology and varying cyclical and product quality demands. Equipment in the middle of its
technical life is left unusedand unplanned to be usedbut not written off because of reluctance
to acknowledge capital write-downs. This reluctance is understandablemarkets do not like
unexpected charges against earningsbut is counterproductive if it results in continued use of
economically unproductive assets. The return on productive assets has to cover the dead weight
load of the unproductive assets.

Asset management for operational decision making has to value each item of equipment annually
according to the expected return from use (or, if higher, from disposal).