270  Forecasting Performance If you tie depreciation to sales, it will incorrectly grow as revenues grow, even when capital expenditures haven’t been made. When using PP&E as the forecast driver, forecast depreciation as a per- centage of net PP&E, rather than gross PP&E. Ideally, depreciation would be linked to gross PP&E, since depreciation for a given asset’s life (assuming straight-line depreciation) equals gross PP&E divided by its expected life. But linking depreciation to gross PP&E requires modeling asset life and retiring the asset when it becomes fully depreciated. Implementing this correctly is tricky. If you forget to model asset retirements, for example, you would over- estimate depreciation (and consequently its tax shield) in the later years. If you have access to detailed, internal information about the company’s assets, you can build formal depreciation tables. For each asset, project depreciation using an appropriate depreciation schedule, asset life, and salvage value. To determine company-wide depreciation, combine the annual depreciation of each asset. Exhibit 13.6 presents a forecast of depreciation, as well as the remaining line items on the income statement. Nonoperating Income  Nonoperating income is generated by nonoperating assets, such as customer loans, nonconsolidated subsidiaries, and other equity investments. Since nonoperating income is typically excluded from free cash flow and the corresponding nonoperating asset is valued separately from core operations, the forecast will not affect the value of core operations. Instead, the primary purposes of nonoperating-income forecasts are cash flow planning and estimating earnings per share. EXHIBIT 13.6  Completed Forecast of the Income Statement Forecast worksheet Income statement % 2019 Forecast 2020 $ million 2019 Forecast 2020 Revenue growth 20.0 20.0 Revenues 240.0 288.0 Cost of goods sold/revenues 37.5 37.5 Cost of goods sold (90.0) (108.0) Selling and general expenses/revenues 18.8 18.8 Selling and general expenses (45.0) (54.0) Depreciationt /net PP&Et–1 9.5 9.5 Depreciation (19.0) (23.8) EBITA 86.0 102.3 Interest rates Interest expense (15.0) (13.8) Interest expense 5.4 5.4 Interest income 2.0 1.2 Interest income 2.0 2.0 Nonoperating income 4.0 5.3 Earnings before taxes (EBT) 77.0 95.0 Nonoperating items Nonoperating-income growth 33.3 33.3 Provision for income taxes (18.0) (22.2) Net income 59.0 72.7 Taxes Operating tax rate 23.4 23.4 Statutory tax rate 24.0 24.0 Effective tax rate 23.4 23.4 Mechanics of Forecasting  271 For nonconsolidated subsidiaries and other equity investments, the forecast methodology depends on how much information is available. For illiquid in- vestments in which the parent company owns less than 20 percent, the company records income only when dividends are received or assets are sold at a gain or loss. For these investments, you cannot use traditional drivers to forecast cash flows; instead, estimate future nonoperating income by examining historical growth in nonoperating income or by examining the revenue and profit fore- casts of publicly traded companies that are comparable to the equity investment. For nonconsolidated subsidiaries with greater than 20 percent ownership, the parent company records income even when it is not paid out. Also, the recorded asset grows as the investment’s retained earnings grow. Thus, you can estimate future income from the nonconsolidated investment either by forecasting a non- operating-income growth rate or by forecasting a return on equity (nonoperating income as a percentage of the appropriate nonoperating asset) consistent with the industry dynamics and competitive position of the subsidiary. Interest Expense and Interest Income  Interest expense (or income) should be tied directly to the liability (or asset) that generates the expense (or income). The appropriate driver for interest expense is total debt. To simplify imple- mentation, use prior-year debt to drive interest expense, rather than same year- end debt. To see why, consider a rise in operating costs. If the company uses debt to fund short-term needs, total debt will rise to cover the financing gap caused by lower profits. This increased debt load will cause interest expense to rise, dropping profits even further. The reduced level of profits, once again, requires more debt. To avoid the complexity of this feedback effect, compute interest expense as a function of the prior year’s total debt. This shortcut will simplify the model and avoid circularity.6 A forecast of interest expense requires data from the income statement and the balance sheet. The balance sheet for our hypothetical company is presented in Exhibit 13.7. From the income statement presented in Exhibit 13.6, start with the 2019 interest expense of $15 million, and divide by 2018’s total debt of $280 million (from the balance sheet, the sum of $200 million in short-term debt plus $80 million in long-term debt). This ratio equals 5.4 per- cent. To estimate the 2020 interest expense, multiply the estimated forecast ratio (5.35 percent) by 2019’s total debt ($258 million), which leads to a fore- cast of $13.8 million. In this example, interest expense is falling even while revenues rise, because total debt is shrinking as the company generates cash from operations. Using historical interest rates to forecast interest expense is a simple, straightforward estimation method. And since interest expense is not part of free cash flow, the choice of how to forecast interest expense will not affect the 6 If you are using last year's debt multiplied by current interest rates to forecast interest expense, the forecast error will be greatest when year-to-year changes in debt are significant.