Financial Projections in Real and Nominal Terms  503 economics of the business. With these approximations, forecast the operating performance of the business in real terms: • Project future revenues and cash expenses to obtain EBITDA forecasts.12 • Estimate PP&E and capital expenditures from your assumptions for real-terms capital turnover. • Working capital follows from projected revenues and assumptions about days of working capital required. • From projected net PP&E and assumptions about the lifetime of the assets, derive the annual depreciation to estimate real-terms EBITA. Step 2: Build Financial Statements in Nominal Terms Nominal projections can be readily derived through the following steps, which convert the real operating projections into nominal terms:13 • Project nominal revenues, cash expenses, EBITDA, and capital expendi- tures by multiplying their real-terms equivalents by an estimated infla- tion index for the year. • Estimate net PP&E on a year-by-year basis from the prior-year balance plus nominal capital expenditures minus nominal depreciation (which is estimated as a percentage of net PP&E according to the estimated asset lifetime). • Project working capital by multiplying the real-terms amounts by the inflation index for the year (or derive from real-terms revenues and days of working capital required). • Subtract the nominal depreciation charges from EBITDA to obtain nominal EBITA. • Calculate income taxes on nominal EBITA without inflation corrections, unless tax laws allow for such corrections. This example did not build a complete balance sheet and income state- ment. Complete financial statements would be needed for major decisions concerning, for example, dividend policy and capital structure, debt financing, 12 This step assumes that all expenses included in EBITDA are cash costs. 13 As noted, these projections are made for valuation purposes and not necessarily in accordance with local or international accounting standards prescribing any inflation or monetary corrections for particular groups of assets and liabilities under, for example, inflation accounting. Free cash flows would not be affected by such adjustments. 504  Inflation and share repurchase. Developing complete nominal financial statements would require the following additional steps: • Forecast interest expense and other nonoperating income statement items in nominal terms (based on the previous year’s balance sheet). • Check that equity equals last year’s equity plus earnings, less dividends, plus or minus any share issues or repurchases. • Balance the balance sheet with debt or marketable securities. Step 3: Build Financial Statements in Real Terms Most of the operating items for the real-terms income statement and balance sheet were already estimated in step 1. Now include the real-terms taxes on EBITA by deflating the nominal taxes as estimated in step 2. For full financial statements, use the inflation index to convert debt, marketable securities, in- terest expense, income taxes, and nonoperating terms from the nominal state- ments into real terms. The real-terms equity account is a plug to balance the balance sheet. To make sure you have done this correctly, be sure the real equity account equals last year’s equity plus earnings, less dividends, plus or minus share issues or repurchases, and plus or minus inflationary gains or losses on the monetary assets and liabilities (such as cash, receivables, pay- ables, and debt). Step 4: Forecast Free Cash Flows in Real and Nominal Terms Forecast the future free cash flows in real and nominal terms from the pro- jected income statements and balance sheets. Follow the general approach de- scribed in Chapter 10. The only difference is that the real-terms investment in net working capital (NWCR) is equal to the increase in working capital plus a monetary loss due to inflation:14 Investment in NWC Increase in NWC NWC 1 R R R t t t t t i i = + +       −1 where it is the inflation rate in year t. To check for consistency, use the inflation index to convert the free cash flows from the nominal projections to real terms. These should equal the free cash flows from the real-terms projections in each year. 14 Even for assets held at constant levels in real-terms balance sheets, replacement investments are required at increasing prices in an inflationary environment. These replacement investments represent a cash outflow, also in real terms, but do not show up from real-terms balance sheet differences from year to year. In contrast, the nominal investment cash flow does follow from the nominal balance sheet differences from year to year.