278  Forecasting Performance on assessing the investments currently owned, not on discounting the forecast changes in their book values and/or their corresponding income. If a forecast is necessary for planning, keep in mind that income from associates is often noncash, and nonoperating assets often grow in a lumpy fashion unrelated to a company’s revenues. To forecast equity investments, rely on historical prec- edent to determine the appropriate level of growth. Regarding deferred-tax assets and liabilities, those used to occur primar- ily through differences in depreciation schedules (investor and tax authorities use different depreciation schedules to determine taxable income). Today, de- ferred taxes arise for many reasons, including tax adjustments for pensions, stock-based compensation, acquired-intangibles amortization, and deferred revenues (see Chapter 20 for an in-depth discussion of deferred taxes). For sophisticated valuations that require extremely detailed forecasts, fore- cast deferred taxes line by line, tying each tax to its appropriate driver. In most situations, forecasting operating deferred taxes by computing the aggregate proportion of taxes likely to be deferred will lead to reasonable results. For instance, if operating taxes are estimated at 23.4 percent of EBITA and the company historically could defer one-fifth of operating taxes paid, we often assume it can defer one-fifth of 23.4 percent going forward. Operating-related deferred-tax liabilities will then increase by the amount deferred. Step 5: Reconcile the Balance Sheet with Investor Funds To complete the balance sheet, forecast the company’s sources of financing. To do this, rely on the rules of accounting. First, use the principle of clean surplus accounting: Equity Equity Net Income Dividends Net Equit 2020 2019 2020 2020 = + − + y Issued2020 Applying this to our earlier example, Exhibit 13.12 presents the state- ment of shareholders’ equity. To estimate equity in 2020, start with 2019 eq- uity of $182 million from Exhibit 13.11. To this value, add the 2020 forecast EXHIBIT 13.12  Statement of Shareholders’ Equity $ million 2018 2019 Forecast 2020 Shareholders’ equity, beginning of year 120.8 145.0 182.0 Net income 40.2 59.0 72.7 Dividends (16.0) (22.0) (27.1) Issuance (repurchase) of common stock – – – Shareholders’ equity, end of year 145.0 182.0 227.6 Dividends/net income, % 39.8 37.3 37.3 Mechanics of Forecasting  279 of net income: $72.7 million from the income statement in Exhibit 13.6. Next, estimate the dividend payout. In 2019, the company paid out 37.3 percent of net income in the form of dividends. Applying a 37.3 percent payout ratio to estimated net income leads to $27.1 million in expected dividends. Finally, add new equity issued net of equity repurchased, which in this example is zero. Using the clean surplus relationship, we estimate 2020 equity at $227.6 million. At this point, four line items on the balance sheet remain: excess cash, short-term debt, long-term debt, and a new account titled “newly issued debt.” Some combination of these line items must make the balance sheet bal- ance. For this reason, these items are often referred to as “the plug.” In simple models, existing debt either remains constant or is retired on schedule, ac- cording to contractual terms.13 To complete the balance sheet, set one of the remaining two items (excess cash or newly issued debt) equal to zero. Then use the primary accounting identity—assets equal liabilities plus sharehold- ers’ equity—to determine the remaining item. Exhibit 13.13 presents the elements of this process for our example. First, hold short-term debt, long-term debt, and common stock constant. Next, sum total assets, excluding excess cash: cash ($6 million), inventory ($54 million), net PP&E ($300 million), and equity investments ($100 million) total $460 million. Then sum total liabilities and equity, excluding newly EXHIBIT 13.13  Forecast Balance Sheet: Sources of Financing $ million 2018 2019 Preliminary 2020F Completed 2020F Assets Step 1: Determine retained earnings using the clean surplus relation, forecast existing debt using contractual terms, and keep common stock constant. Operating cash 5.0 5.0 6.0 6.0 Excess cash 100.0 60.0 49.6 Inventory 35.0 45.0 54.0 54.0 Current assets 140.0 110.0 60.0 109.6 Net PP&E 200.0 250.0 300.0 300.0 Equity investments 100.0 100.0 100.0 100.0 Step 2: Test which is higher: (a) assets excluding excess cash or (b) liabilities and equity, excluding newly issued debt. Total assets 440.0 460.0 460.0 509.6 Liabilities and equity Step 3: If assets excluding excess cash are higher, set excess cash equal to zero, and plug the difference with the newly issued debt. Otherwise, plug with excess cash. Accounts payable 15.0 20.0 24.0 24.0 Short-term debt 200.0 178.0 178.0 178.0 Current liabilities 215.0 198.0 202.0 202.0 Long-term debt 80.0 80.0 80.0 80.0 Newly issued debt – – – Shareholders’ equity 145.0 182.0 227.6 227.6 Total liabilities and equity 440.0 460.0 509.6 509.6 13 Given the importance of debt in a leveraged buyout, buyout models often contain a separate work- sheet detailing interest and principal repayment by year for each debt contract.