Building Business Unit Financial Statements  403 eliminate the ­nonoperating effect of pension expense), and operating lease adjustment (eliminating interest expense embedded in rental expense before new accounting standards were introduced in 2019) to each of the business units. (For more information on these adjustments, see Chapter 11.) Use the overall operating tax rate for all business units unless you have information to estimate each unit’s tax rate—for example, if units are in different tax juris- dictions. For the ConsumerCo example, this would have resulted in exactly the right NOPAT per business unit, because no pension, lease, or other adjust- ments are needed on reported EBITA, though this is not typically the case. After estimating NOPAT, reconcile the sum of all business unit NOPATs to consolidated net income. This step ensures that all adjustments have been properly made. Invested Capital  To estimate invested capital, you can use an incremental approach or a proportional approach, depending on the information avail- able. When possible, use both approaches to triangulate your estimates. In the incremental approach, start with total assets by business unit, and subtract estimates for nonoperating assets and non-interest-bearing operating liabilities. (Note that many companies will hold nonoperating assets at the corporate level, not the unit level. In that case, no adjustment is necessary.) Nonoperating assets include excess cash, investments in nonconsolidated sub- sidiaries, pension assets, and deferred tax assets. Non-interest-bearing operat- ing liabilities include accounts payable, taxes payable, and accrued expenses. They can be allocated to the business units by either revenue or total assets. As discussed in the earlier section on intercompany payables and receivables, do not treat intercompany loans and debt as an operating liability. Then allocate the invested capital for the consolidated entity to all of its business units by the amount of total assets minus nonoperating as- sets and non-interest-bearing liabilities for each business unit. To measure invested capital excluding goodwill,6 subtract allocated goodwill by busi- ness unit. If goodwill is not reported by business unit, you can try to make an estimate from past transactions if these can be aligned with individual business units. Using the proportional approach for ConsumerCo, you could have allo- cated its total operating invested capital (excluding the customer loans and joint venture, of course) to each of the business units by each unit’s propor- tion of total assets as reported before intersegment eliminations. Note that this would have resulted in some estimation errors, such as allocating $1,711 ­million ­invested capital (calculated as $1,872/$4,712 × $4,306 million) to branded products when its true invested capital is $1,600 million. 6 By goodwill, we mean both goodwill and acquired intangibles. 404  Valuation by Parts Once you have estimated invested capital for the business units and cor- porate center, reconcile these estimates with the total invested capital derived from the consolidated statements. Cost of Capital Each business segment should be valued at its own cost of capital, because the systematic risk (beta) of operating cash flows and their ability to support debt—that is, the implied capital structure—will differ by business. To deter- mine an operational business unit’s weighted average cost of capital (WACC), you need the unit’s target capital structure, its cost of equity (as determined by its levered beta), and its cost of borrowing. For a financial business, you simply need the cost of equity following from its equity beta. (For details on estimating the cost of equity and WACC, see Chapter 15.) The results for Con- sumerCo’s segments are summarized in Exhibit 19.8. First, estimate the target capital structure in terms of the debt-to-equity (D/E) ratio for each of ConsumerCo’s business units. We recommend using the median capital structure of publicly traded peers, especially if most peers have similar capital structures. Next, determine the levered beta, cost of eq- uity, and WACC. To determine a business unit’s beta, first estimate an unle- vered median beta for its peer group (be thoughtful about which companies to include, especially outliers). Relever the beta, using the same business unit’s EXHIBIT 19.8  ConsumerCo: WACC Estimates, January 2020 Business Debt/ equity1 Cost of debt,2 % Beta, unlevered Beta, levered Cost of equity,3 % WACC,4 % DCF value, $ million Implied debt, $ million Branded products 0.30 5.5 0.9 1.1 10.1 8.6 5,188 1,197 Private label 0.30 5.5 1.0 1.2 10.7 9.1 1,128 260 Devices 0.25 5.5 1.2 1.5 11.8 10.1 1,474 295 Organic products 0.25 5.5 0.9 1.1 9.9 8.6 3,440 688 Corporate center 0.30 9.4 (1,123) (259) Eliminations – – Total operations 10,107 2,181 Customer finance 1,038 Total ConsumerCo: Net debt, implied 3,220 Excess cash, actual (250) Debt, actual in operations 1,941 Debt, actual in customer finance 1,038 Total ConsumerCo: Net debt, actual 2,730 1 At targeted BBB credit rating. 2 Beta of debt equals 0.2 and risk-free rate of interest equals 4.5%. 3 Assuming market risk premium of 5.0%. 4 Tax rate set at 35%.