**What should you
subtract out to get to equity value?**

The
general rule that you should use is that the debt you subtract from the value
of the firm should be at least equal to the debt that you use to compute the
cost of capital. Thus, if you decide to capitalize operating leases as debt, as
we did with the Gap in the last chapter, to compute the cost of capital, you
should subtract out the debt value of operating leases from the value of
operating assets to estimate the value of equity. If the firm you are valuing
has preferred stock, you would use the market value of the stock (if it is
traded) or estimate a market value[1] (if it is not) and deduct it from firm
value to get to the value of common equity.

There
may be other claims on the firm that do not show up in debt that you should
subtract out from firm value.

*Expected liabilities on lawsuits*: You could be analyzing a firm that is the defendant in a lawsuit, where it potentially could have to pay tens of millions of dollars in damages. You should estimate the probability that this will occur and use this probability to estimate the expected liability. Thus, if there is a 10% chance that you could lose a case that you are defending and the expected damage award is $1 billion, you would reduce the value of the firm by $100 million (probability * expected damages). If the expected liability is not anticipated until several years from now, you would compute the present value of the payment.*Unfunded Pension and Health Care Obligations*: If a firm has significantly underfunded a pension or a health plan, it will need to set aside cash in future years to meet these obligations. While it would not be considered debt for cost of capital purposes, it should be subtracted from firm value to arrive at equity value.*Deferred Tax Liability*: The deferred tax liability that shows up on the financial statements of many firms reflects the fact that firms often use tax deferral strategies that reduce their taxes in the current year while increasing their taxes in the future years. Of the three items listed here, this one is the least clearly defined, since it is not clear when or even whether the obligation will come due. Ignoring it, though, may be foolhardy, since the firm could find itself making these tax payments in the future. The most sensible way of dealing with this item is to consider it an obligation, but one that will come due only when the firmÕs growth rate moderates. Thus, if you expect your firm to be in stable growth in 10 years, you would discount the deferred tax liability back ten years and deduct this amount from the firm value to get to equity value.

[1] Estimating market value for preferred stock is relatively simple. Preferred stock generally is perpetual and the estimated market value of the preferred stock is therefore:

Value of preferred stock

The cost of preferred stock should be higher than the pre-tax cost of debt, since debt has a prior claim on the cash flows and assets of the firm.