280  Forecasting Performance issued debt: accounts payable ($24 million), short-term debt ($178 million), long-term debt ($80 million), and shareholders’ equity ($227.6 million) total $509.6 million. Because liabilities and equity (excluding newly issued debt) are greater than assets (excluding excess cash), newly issued debt is set to zero. Now total liabilities and equity equal $509.6 million. To ensure that the balance sheet balances, we set the only remaining item, excess cash, equal to $49.6 million. This increases total assets to $509.6 million, and the balance sheet is complete. To implement this procedure in a spreadsheet, use the spreadsheet’s prebuilt If function. Set up the function so it sets excess cash to zero when assets (excluding excess cash) exceed liabilities and equity (excluding newly issued debt). Conversely, if assets are less than liabilities and equity, the function should set short-term debt equal to zero and excess cash equal to the difference. The Link Between Capital Structure Forecasts and Valuation  When using excess cash and newly issued debt to complete the balance sheet, you will likely encounter one common side effect: as growth drops, newly issued debt will drop to zero, and excess cash will become very large.14 But what if a drop in leverage is inconsistent with your long-term assessments concerning capi- tal structure? In an enterprise DCF valuation that uses the weighted average cost of capital for discounting, this side effect does not matter. Excess cash and debt are not included as part of free cash flow, so they do not affect the enterprise valuation. Capital structure affects enterprise DCF only through the weighted average cost of capital.15 Thus, only an adjustment to WACC will lead to a change in valuation. To bring the capital structure on the balance sheet in line with the capital structure implied by WACC, adjust the dividend payout ratio or amount of net share repurchases. For instance, as the dividend payout is increased, re- tained earnings will drop, and this should cause excess cash to drop as well. By varying the payout ratio (both dividends and share repurchases), you can also test how robust your FCF model is. Specifically, ROIC and FCF, and hence value, should not change when the dividend rate or amount of share repur- chases is adjusted. How you choose to model the payout ratio depends on the requirements of the model. In most situations, you can adjust the dividend payout ratio 14 Whenever ROIC is greater than revenue growth, a company will generate operating cash flow; that is, the investment rate will be negative. If dividends or share repurchases are not increased to disgorge cash, debt will drop, and/or excess cash will accumulate. 15 In the APV model, your forecast of debt will affect valuation. Interest tax shields are computed year by year based on the amount of debt, the interest rate, and the tax rate. Models that discount with a constant WACC implicitly assume debt-to-value never changes, such that balance sheet forecasts are ignored. Advanced Forecasting  281 or amount of repurchases by hand when needed (remember, the ratio does not affect value but rather brings excess cash and newly issued debt closer to reality). For more complex models, determine net debt (total debt less excess cash) by applying the target net-debt-to-value ratio modeled in the WACC at each point in time. Next, using the target debt-to-value ratio, solve for the required payout. To do this, however, you must perform a valuation in each forecast year and iterate backward—a time-consuming process for a feature that will not affect the final valuation.16 Step 6: Calculate ROIC and FCF Once you have completed your income statement and balance sheet forecasts, calculate ROIC and FCF for each forecast year. This process should be straight- forward if you have already computed ROIC and FCF historically. Since a full set of forecast financials is now available, merely copy the two calculations from historical financials to projected financials. For companies that are creating value, future ROICs should fit one of three general patterns: ROIC should either remain near current levels (when the company has a distinguishable sustainable advantage), trend toward an in- dustry or economic median, or trend to the cost of capital. Think through the economics of the business to decide what is appropriate. For more on long- term trends of ROIC, refer to Chapter 8. Advanced Forecasting The preceding sections detailed the process for creating a comprehensive set of financial forecasts. When forecasting, you are likely to come across three advanced issues: forecasting using nonfinancial operating drivers, forecasting using fixed and variable costs, and handling the impact of inflation. Nonfinancial Operating Drivers Until now, the chapter has created forecasts that rely solely on financial drivers. In industries where prices are changing or technology is advanc- ing, forecasts should incorporate nonfinancial ratios, such as volume and productivity. Consider the turmoil in the airline industry during the early 2000s. Fares requiring Saturday-night stays and advance purchases disappeared as 16 To value Costco in Appendix H, we modeled a constant leverage ratio year by year and iterated back- ward. While iteration is not necessary to value a company more generally, it is required to ensure that the enterprise DCF valuation ties to other valuation methodologies, such as cash-flow-to-equity models.