Enterprise Discounted Cash Flow Model  183 EXHIBIT 10.6  GlobalCo: Balance Sheet $ million Forecast Historical Year 1 Year 2 Year 3 Cash 4.0 5.0 5.8 6.0 Accounts receivable 20.0 25.0 28.8 30.2 Inventories 40.0 50.0 57.5 60.4 Current assets 64.0 80.0 92.0 96.6   Property and equipment 200.0 250.0 287.5 301.9 Goodwill and acquired intangibles 100.0 100.0 100.0 100.0 Total assets 364.0 430.0 479.5 498.5   Liabilities and equity Short-term debt 110.0 110.0 125.4 134.0 Accounts payable 16.0 20.0 23.0 24.2 Current liabilities 126.0 130.0 148.4 158.2   Long-term debt 140.0 160.0 160.0 160.0 Shareholders’ equity 98.0 140.0 171.1 180.3 Total liabilities and equity 364.0 430.0 479.5 498.5 In Exhibit 10.7, we reorganize the income statement into NOPAT. To esti- mate NOPAT, deduct only operating costs and depreciation from revenue. Do not deduct interest expense or add nonoperating income; they will be ana- lyzed and valued separately as part of nonoperating assets and debt, respec- tively. Operating taxes are computed on operating profit and represent the level of taxes that would be paid if the firm were financed entirely by equity and held only operating assets. A robust valuation will reconcile net income EXHIBIT 10.7  GlobalCo: Net Operating Profit after Taxes (NOPAT) $ million Forecast Historical Year 1 Year 2 Year 3 Continuing value Revenue 200.0 250.0 287.5 301.9 308.5 Operating costs (120.0) (150.0) (172.5) (181.1) (185.1) Depreciation (20.0) (25.0) (28.8) (30.2) (30.9) Operating profit 60.0 75.0 86.3 90.6 92.6   Operating taxes (12.0) (15.0) (17.3) (18.1) (18.5) NOPAT 48.0 60.0 69.0 72.5 74.0 Reconciliation to net income Net income 40.8 52.0 60.4 63.3 64.6 Interest expense 9.0 10.0 10.8 11.4 11.8 Interest tax shield (1.8) (2.0) (2.2) (2.3) (2.4) NOPAT 48.0 60.0 69.0 72.5 74.0 184  Frameworks for Valuation EXHIBIT 10.8  GlobalCo: Invested Capital and Total Funds Invested $ million Forecast Historical Year 1 Year 2 Year 3 Working capital 48.0 60.0 69.0 72.5 Property, plant, and equipment, net 200.0 250.0 287.5 301.9 Invested capital, excluding goodwill 248.0 310.0 356.5 374.3 Goodwill and acquired intangibles 100.0 100.0 100.0 100.0 Invested capital, including goodwill 348.0 410.0 456.5 474.3 Nonoperating assets – – – – Total funds invested 348.0 410.0 456.5 474.3 Reconciliation of total funds invested Short-term debt 110.0 110.0 125.4 134.0 Long-term debt 140.0 160.0 160.0 160.0 Debt and debt equivalents 250.0 270.0 285.4 294.0 Shareholders’ equity 98.0 140.0 171.1 180.3 Total funds invested 348.0 410.0 456.5 474.3 to NOPAT. The reconciliation will prevent unintended errors and force explicit choices about how each piece of data will be incorporated in the valuation. In Exhibit 10.8, we reorganize the balance sheet into invested capital and total funds invested. Invested capital includes working capital, property, plant, equipment, and other operating assets, net of other operating liabilities. Measure invested capital both including and excluding goodwill and acquired intangibles. By analyzing invested capital with and without goodwill, we can assess the impact of acquisitions on past performance. A company with robust margins and lean operations can have low ROIC with goodwill because of the high prices it paid for acquisitions. GlobalCo holds only operating assets, so invested capital equals total funds invested. Since nonoperating assets are typically valued using methods other than DCF, we explicitly distinguish them from operating assets and operating liabilities. Next, reconcile total funds invested with sources of capital: debt, equity, and their equivalents. Examples of debt equivalents include unfunded pension obligations and environmental-remediation liabilities. Examples of equity equivalents include deferred taxes. To calculate ROIC in year 1, divide NOPAT by the prior-year invested capital.8 In year 1, ROIC excluding goodwill equals 24.2 percent ($60/$248), and ROIC including goodwill equals 17.2 percent ($60/$348). Because ROIC 8 In this calculation, we estimate ROIC using prior-year invested capital (that is, measured at the begin- ning of the year) to link our enterprise DCF valuation with an economic profit valuation presented later in this chapter. When benchmarking performance, use a two-year average of invested capital. Enterprise Discounted Cash Flow Model  185 is greater than the cost of capital of 7.8 percent, the company is creating value, both with and without the effect of acquisition premiums. Analyzing Historical Performance  Once the company’s financial statements are reorganized into NOPAT and invested capital, analyze the company’s his- torical financial performance. By thoroughly analyzing the past, we can un- derstand whether the company has created value, how fast it has grown, and how it compares with its competitors. A good analysis will focus on the key drivers of value: return on invested capital, revenue growth, and free cash flow. Understanding how these drivers behaved in the past will help you make more reliable estimates of future cash flow. Exhibit 10.9 presents a historical analysis of organic revenue growth and ROIC. GlobalCo has been performing well, with organic growth rates and EXHIBIT 10.9  GlobalCo: Forecast Revenue Growth and ROIC % Organic revenue growth Historical Forecast Historical Forecast Historical Forecast Year –4 ROIC excluding goodwill and intangibles1 ROIC including goodwill and intangibles1 15.0 Year –3 30.0 Year –2 23.0 Last fiscal year 28.0 Year 1 25.0 Year 2 15.0 Year 3 5.0 Continuing value 2.2 Year –4 24.7 Year –3 28.4 Year –2 29.9 Last fiscal year 28.1 Year 1 24.1 Year 2 22.3 Year 3 20.3 Continuing value 19.8 Year –4 17.6 Year –3 20.2 Year –2 21.3 Last fiscal year 20.0 Year 1 17.2 Year 2 16.8 Year 3 15.9 Continuing value 15.6 1 Measured using beginning-of-year capital to match economic-profit models presented later in the chapter.