272  Forecasting Performance company’s valuation (only free cash flow drives valuation; the cost of debt is modeled as part of the weighted average cost of capital).7 When a company’s financial structure is a critical part of the forecast, however, split debt into two categories: existing debt and new debt. Until repaid, existing debt should generate interest expense consistent with contractual rates reported in the company’s financial notes. Interest expense based on new debt, in contrast, should be paid at current market rates, available from a financial data service. Projected interest expense should be calculated using a yield to maturity for comparably rated debt at a similar duration. Estimate interest income the same way, with forecasts based on the asset generating the income. Be careful: interest income can be generated by mul- tiple investments, including excess cash, short-term investments, customer loans, and other long-term investments. If a footnote details the historical relationship between interest income and the assets that generate the in- come (and the relationship is material), develop a separate calculation for each asset. Income Taxes  Do not forecast the provision for income taxes as a percentage of earnings before taxes. If you do, ROIC and FCF in forecast years will inad- vertently change as leverage and nonoperating income change. Instead, start with a forecast of operating taxes on EBITA, and adjust for taxes related to nonoperating accounts, such as interest expense. Use this combined number to generate taxes on the income statement. Exhibit 13.8 presents the forecast process for income taxes. To forecast oper- ating taxes for 2020, multiply earnings before interest, taxes, and amortization (EBITA) by the operating tax rate (23.4 percent). Earlier, we estimated EBITA equal to $102.3 million for 2020. Do not use the statutory tax rate to forecast operating taxes. Many companies pay taxes at rates below their local statutory rate because EXHIBIT 13.7  Historical Balance Sheet $ million Assets 2018 2019 Liabilities and shareholders’ equity 2018 2019 Operating cash 5.0 5.0 Accounts payable 15.0 20.0 Excess cash 100.0 60.0 Short-term debt 200.0 178.0 Inventory 35.0 45.0 Current liabilities 215.0 198.0 Current assets 140.0 110.0 Long-term debt 80.0 80.0 Net PP&E 200.0 250.0 Shareholders’ equity 145.0 182.0 Equity investments 100.0 100.0 Total liabilities and equity 440.0 460.0 Total assets 440.0 460.0 7 In a WACC-based valuation model, the cost of debt and its associated tax shields are fully incorpo- rated in the cost of capital. In an adjusted present value (APV) model, the interest tax shield is valued separately using a forecast of interest expense. Mechanics of Forecasting  273 of low foreign rates and operating tax credits.8 Failure to recognize operating credits can cause errors in forecasts and an incorrect valuation. Also, if you use historical tax rates to forecast future tax rates, you implicitly assume that these spe- cial incentives will grow in line with EBITA. If this is not the case, EBITA should be taxed at the marginal rate, and tax credits should be forecast one by one. Next, forecast the taxes related to nonoperating accounts. Although such taxes are not part of free cash flow, a robust forecast of them will provide in- sights about future net income and cash needs. For each line item between EBITA and earnings before taxes, compute the marginal taxes related to that item. If the company does not report each item’s marginal tax rate, use the country’s statu- tory rate. In Exhibit 13.8, the cumulative net nonoperating expense ($7.3 million in 2020) was multiplied by the marginal tax rate of 24 percent. It is possible to do this because each item’s marginal income tax rate is the same. When marginal tax rates differ across nonoperating items, forecast nonoperating taxes line by line. To determine the 2020 provision for income taxes, sum operating taxes ($24.0 million) and taxes related to nonoperating accounts (−$1.8 million). You now have a forecast of $22.2 million for reported taxes, calculated such that future values of FCF and ROIC will not change with leverage. Step 4: Forecast the Balance Sheet: Invested Capital and Nonoperating Assets To forecast the balance sheet, start with items related to invested capital and nonoperating assets. Do not forecast excess cash or sources of financing (such as debt and equity). Excess cash and sources of financing require special treat- ment and will be handled in step 5. EXHIBIT 13.8  Forecast of Reported Taxes $ million 2019 Forecast 2020 Operating taxes EBITA 86.0 102.3 × Operating tax rate 23.4% 23.4% = Operating taxes 20.2 24.0 Taxes on nonoperating accounts Interest expense (15.0) (13.8) Interest income 2.0 1.2 Nonoperating income 4.0 5.3 Nonoperating income (expenses), net (9.0) (7.3) × Marginal tax rate 24.0% 24.0% = Nonoperating taxes (2.2) (1.8) Provision for income taxes1 18.0 22.2 1 The provision for income taxes equals the sum of operating and nonoperating taxes. 8 For an in-depth discussion on the difference between statutory, effective, and operating tax rates, see Chapter 20.