Closing Thoughts  425
against the loss carryforward. If information allows, apply past losses 
against projections of future income to estimate the timing of tax savings. 
Discount these cash flows at an appropriate cost of capital, such as the 
unlevered cost of equity. Be careful to check with local tax experts, since 
the statutes governing tax loss carryforwards are complex. Also keep in 
mind that tax loss carryforwards are country specific. A company with tax 
loss carryforwards in one country cannot use the benefit against profits 
in another country. For more on tax loss carryforwards and how to value 
them, see Chapter 16.
Deferred-tax liabilities related to acquired intangibles are netted against 
intangible assets and ignored. As described in the previous section, amortiza-
tion is noncash and, in many countries, nondeductible. Thus, amortization 
and its corresponding deferred-tax liability have no effect on cash flow.5
To value the remaining deferred-tax accounts, including pensions and con-
vertible debt, turn to their corresponding accounts. How you will do this de-
pends on the nuances of the account. As an example, deferred taxes related to 
pensions arise when pension expense differs from the cash contribution. But 
the deferred-tax account recognized on the balance sheet reflects accumulated 
historical differences, not future tax savings. Therefore, to value the tax shield 
associated with unfunded pensions, multiply the current unfunded liability 
by the marginal tax rate (that is, the expected tax savings attributable to fund-
ing the shortfall). We can do this because under U.S. law, cash contributions 
to close gaps in funding are tax deductible.
Regardless of the deferred-tax account, never use the book value of the 
account to approximate value. Deferred-tax accounts reflect past differences 
between accounting and tax statements. They reflect neither future cash flows 
nor the present value of those flows.
Closing Thoughts
Accounting for taxes is complex and can be daunting for even the most sea-
soned professional. However, given the number of companies whose oper-
ating tax rates consistently differ from both the statutory tax rate and the 
effective tax rate, a careful assessment of the operating tax rate is critical to an 
accurate valuation.
If you are confused about a particular line item in the tax reconciliation 
table, rely on the general principles of this book by asking two questions: First, 
5 Some treat the deferred-tax liability as operating and embed it in free cash flow using the following 
logic. First, operating taxes are calculated on EBIT, not EBITA. If amortization is not deductible, the 
resulting estimate for taxes is too low. As the deferred-tax liability declines, this implies a negative 
cash flow. This decline offsets the amortization tax shield generated by using EBIT. However, since we 
compute operating taxes on EBITA, we ignore the amortization tax shield and consequently do not 
apply the offset.

426  Taxes
is the item ongoing and related to core operations? Second, does the item ma-
terially change your perception of the company’s performance or valuation? 
Finally, when converting from operating taxes to cash operating taxes, always 
assess whether the deferral rate is reasonable and can be continued. Perhaps 
an acquisition is causing an artificial jump in a deferred-tax account, making 
the deferral rate uncharacteristically high. If so, use long-term trends to fore-
cast future deferral rates.

427
21
Nonoperating Items, 
Provisions, and Reserves
To project free cash flow, you would typically focus on operating expenses, 
such as cost of sales, distribution expenses, selling expenses, and administra-
tive expenses. But what about nonoperating expenses, such as business re-
alignment expenses, goodwill impairment, and extraordinary items?
Nonoperating expenses are infrequent or unusual charges that are indi-
rectly related to the company’s typical activities and not expected to recur. 
The conventional wisdom is that discounted-cash-flow (DCF) calculations 
should ignore nonoperating expenses as backward-looking, one-time costs. 
Yet research shows that the type and accounting treatment of nonoperating 
expenses can affect future cash flow and in certain situations must be incor-
porated into your valuation.
This chapter analyzes the most common nonoperating expenses. These 
include the amortization of acquired intangibles, restructuring charges, un-
usual charges such as litigation expenses, asset write-offs, and goodwill im-
pairments. Since noncash expenses will be accompanied by a corresponding 
provision, we create a classification system of various provisions and describe 
the process for reorganizing the income statement and balance sheet to reflect 
the true effect of such provisions, if any, on company value. We show how to 
treat provisions in free cash flow and equity valuation.
Nonoperating Expenses and One-Time Charges
Given their infrequent nature, nonoperating expenses and one-time charges 
can distort a company’s historical financial performance and consequently 
­distort our view of the future. It is therefore critical to separate one-time