Valuing Debt Equivalents  347 2. Long-term operating provisions (e.g., plant-decommissioning costs) should be deducted from enterprise value as debt equivalents. Because these provisions cover cash expenses that are payable in the long term, they are recorded at the discounted value in the balance sheet. In this case, there is no need to perform a separate DCF analysis, and you can use the book value of the liability in your valuation.17 3. Nonoperating provisions (in cases such as restructuring charges re- sulting from layoffs) should be deducted from enterprise value as a debt equivalent. Although a discounted value would be ideal, the book value from the balance sheet is often a reasonable approximation. These provi- sions are recorded on the financial statements at a nondiscounted value, because outlays are usually made in the near term. 4. Income-smoothing provisions should be eliminated from NOPAT. Con- sequently, they should not be deducted from enterprise value. For an ex- ample of income smoothing, see the sale-leaseback example for FedEx presented at the end of Chapter 11. Leases Starting in 2019, companies are required to recognize nearly all leases, includ- ing operating leases, on the balance sheet. For companies that report using IFRS, lease-related interest is recorded as a financial expense, and lease-related liabilities are incorporated within debt. Therefore, no adjustment is required. For companies that report using U.S. GAAP, there are two types of leases: finance leases and operating leases. The treatment of finance leases is identical to IFRS, so no adjustment to enterprise value is required. In contrast, operat- ing leases require special care. To determine equity value, remove embedded interest from operating expense, include the year-to-year change in “right- to-use” assets in free cash flow, and deduct the operating-lease liability from enterprise value to determine equity value.18 To value equity consistently, all three actions are required. If you choose not to adjust for embedded interest or include the change of “right-to-use” assets on free cash flow, do not subtract the value of operating leases. Chapter 22 details the new accounting rules, required adjustments, and valuation of leases. Unfunded Retirement Obligations Unfunded retirement obligations, such as unfunded pensions and post- retirement medical benefits, should be treated as debt equivalents and 17 The company will also recognize a decommissioning asset at the time of initial investment. The decommissioning asset is already incorporated into free cash flow, so no adjustment for the asset is required. 18 For a more comprehensive summary, see the Operating Leases section of Chapter 11. 348  Moving from Enterprise Value to Value per Share deducted from enterprise value to determine equity value. Since the future contributions to eliminate unfunded liabilities are tax deductible at the mar- ginal tax rate, multiply unfunded pension liabilities by 1 minus the statutory in- come tax rate. For details on pension accounting and valuation, see Chapter 23. Contingent Liabilities Certain liabilities are not disclosed in the balance sheet but are separately discussed in the notes to the balance sheet. Examples are possible liabilities from pending litigation and loan guarantees. When possible, estimate each liability’s expected after-tax cash flows (if the costs are tax deductible), and discount these at the cost of debt. Unfortunately, an external assessment of the probability of such cash flows materializing is challenging, so the valu- ation should be interpreted with caution. To provide some boundaries on your final valuation, estimate the value of contingent liabilities for a range of probabilities. Valuing Hybrid Securities and Noncontrolling Interests For stable, profitable companies, the current values of debt and debt equiva- lents are typically independent of enterprise value. For hybrid securities and noncontrolling interests, this is not the case. Each must be valued in conjunc- tion with estimates of enterprise value. The most common hybrid securi- ties are convertible debt, convertible preferred stock, and employee stock options. We will detail the treatment of all three, as well as noncontrolling interests. Convertible Securities Convertible bonds are corporate bonds that can be exchanged for common equity at a predetermined conversion ratio.19 Convertible preferred stock has the same basic structure as convertible bonds, except convertible stock often comes with other rights of control, such as board seats. Both have become a major source of financing for publicly traded technology companies.20 A con- vertible bond is essentially a package of a straight corporate bond plus a call option on equity (the conversion option). Because the conversion option can have significant value, this form of debt requires treatment different from that of regular corporate debt. 19 For more on convertible bonds, see R. Brealey, S. Myers, and F. Allen, Principles of Corporate Finance, 12th ed. (New York: McGraw-Hill, 2017), chap. 24. 20 R. Molla, “Tech Companies Are Taking Out Record Amounts of Convertible Debt. Here’s Why,” Vox, June 20, 2018, www.vox.com.