838  Appendix H capitalized. Given this circumstance, we add the capitalized value of leases to invested capital and the reconciliation of total funds invested. Going forward, this step will no longer be necessary. Chapter 22 explains how to adjust for operating leases under the new standards. Exhibit 22.10 demonstrates how to value operating leases for 2019, the last year of our Costco historical data, by using the present value of rental commitments. Exhibit H.9: Reconciliation of Total Funds Invested. To better understand how the business is financed and to assure accuracy through a second set of calcu- lations, recalculate total funds invested, but this time using sources of capital. Exhibit H.9 calculates debt and debt equivalents, which include capitalized operating leases. Equity includes common stock and retained earnings. Equity equivalents include deferred-tax accounts, except for tax loss carryforwards. For Costco, the deferred-tax accounts are negative in some years and act as an offset to equity because deferred-tax assets are larger than the corresponding liabilities. Costco’s total funds invested are financed mostly by equity. For more on how to evaluate and create an appropriate capital structure to support the operations of a business, see Chapter 33. Forecasting the Financials For each financial statement, we present a ten-year forecast. Chapter 13 dem- onstrates how to create a set of forecasts, link your forecasts to the financial statements, and avoid common pitfalls. Exhibit H.10: Income Statement Forecast Ratios. To estimate revenue growth and cost of sales for Costco, we rely on analyst reports from September 2019. One such report is detailed in Exhibit 13.3. We forecast the remaining accounts using financial ratios from either the last fiscal year or an average of the last five fiscal years, depending on the account’s stability. To forecast the interest expense on debt, we estimate interest expense as a percentage of prior-year debt. Since we value operations using free cash flow, our forecast of interest expense will not affect the value of operations. We create a forecast solely for the purpose of cash flow planning and to create an integrated set of financial statements. Integrated financials reduce the likeli- hood of modeling errors. Exhibit H.11: Balance Sheet Forecast Ratios. For the balance sheet, we orga- nize the forecast ratios into working capital, long-term assets, debt, and equity. Most working-capital items are forecast using days in revenues. The excep- tions are merchandise inventories and accounts payable, which are linked to merchandise cost. Long-term assets and liabilities are estimated at a constant percent of revenues. To estimate leverage, we assume Costco will maintain its current debt- to-value ratio. We then split total leverage across short-term debt, long-term Appendix H  839 debt, and capital leases based on the five-year averages. Stock-based compen- sation is forecast as a percent of revenues. Dividends are forecast as a percent of net income. Excess cash is paid out over five years, and cash flows not required for investment, payments to debt holders, or dividends are used to repurchase shares. (Share repurchases become a plug in this model to balance the cash flows after all other items are accounted for.) While the forecasts related to debt and share repurchases affect the income statement and balance sheet, they will have no effect on value in an enterprise DCF. Capital structure affects valuation only through the weighted average cost of capital (WACC). Exhibit H.12: Free Cash Flow and Cash Flow to Investors. Exhibit H.12 shows how free cash flow is estimated. Most accounts, such as operating working capital, equal the change in the corresponding invested-capital ac- count. Capital expenditures are reported on the statement of cash flows. Be- cause of currency translations, capital expenditures do not equal the change in net property, plant, and equipment plus depreciation. The link between capi- tal expenditures and the change in net property, plant, and equipment (PP&E) is detailed in Exhibit 11.14. Unexplained currency translations are treated as a nonoperating cash flow.1 Exhibit H.13: Reconciliation of Cash Flow to Investors. To reconcile cash flow to investors, we accumulate the changes in debt and equity accounts. Debt includes traditional debt, capital leases, and capitalized operating leases. Equity includes stock-based compensation, repurchases of common stock, dividends, and payments to noncontrolling interests. Estimating Continuing Value Next, use a continuing-value formula to estimate the value of cash flows be- yond the explicit forecast period. Start using the continuing-value formula only at the point when the company has reached a steady state. Exhibit H.14: Continuing Value. We use the key value driver formula to es- timate continuing value. The formula requires a forecast of NOPAT in 2030 (known as the continuing-value year, abbreviated as CV in Exhibits H.1, H.5, H.6, H.10, and H.17) to determine the continuing value as of 2029. We do not generate forecasts for continuing value for invested capital or free cash flow in the continuing-value year; they are unnecessary for the calculation. One critical forecast in the continuing value is long-run revenue growth. Given the historical strength of Costco’s ability to grow, we use a growth rate 1 If the data are available. Currency translations should be netted against their corresponding account. This will bring the change in the account closer to the true cash inflow or outflow.