Reading: Extensions and FAQ

In many instances, the "operating expenses" that are listed in the firm's income statement might contain some payments that are actually not part of the firm's operating activity. 

An entrepreneur, for example, might pay herself a salary that is larger than the market standard to avoid double-taxation on dividend income. In such a case, part of the "salary" payment listed in the operating expenses is an actual compensation for the work she does for the company. This is an operating expense. The rest, however, is what is called a "hidden distribution of profits" or "disguised dividend." The entrepreneur receives that money instead of a dividend payment. Economically, this constitutes a cash flow from equity financing and we should treat it as such (along with the associated tax savings).

Let's look at this with a numerical example.

Suppose we have the following information about a firm:

• Net income is 5 million
• The operating expenses list a salary of 1 million for the entrepeneur
• The CEOs of comparable companies make 300'000
• The firm's tax rate is 30%
• There is no debt outstanding.

The information imply that the entrepreneur has received disguised dividends of 700'000 [= 1'000'000 - 300'000]. Consequently, the reported net income understates the firm's "true" profitability. To estimate the firm's NOPLAT, we therefore add the after-tax value of the disguised dividends to the firm's net income:

Disguised dividends after taxes = 700'000 × (1 - 0.3) = 490'000.

NOPLAT = Net income + Disguised dividends after taxes (+ other adjustments) = 5'000'000 + 490'000 = 5'490'000.

(In this particular example, we assume that the firm has no debt outstanding. This is why we do not add-back any after-tax interest expenses to obtain NOPLAT)

Later in the cash flow statement, we would subtract the disguised dividends (after taxes) from the residual cash flow to obtain the firm's change in excess cash.