Answer to this Technical Question

Someone can correct me if I'm wrong, but this is how I learned it.

If you think of it from a takeover perspective:

In the event someone was going to take the firm over, they could steal all of the companies cash when they buy it. This is the reason companies with a lot of cash on hand are solid takeover targets. Meanwhile, if they took this same firm over, that carries a lot of debt, they would be forced to pay off the debt of the company they are taking over. For this reason, the value or purchase price of the firm is increased.

For future reference as well, you should also include adding minority interest into the calculation.

Enterprise value = equity value + preferred stock + total debt + minority interest - cash. Also, net debt = total debt - cash EV = equity + preferred + net debt + minority interest.

The reasoning is that you want to use net debt instead of total debt because you assume that at any given time, the firm can use its cash to pay off its debt. You add debt because the acquirer can not take over a company by solely purchasing the equity - it also has to take on the target's debt. On the other hand, you also get the company's cash. Assume the company had $500 in debt and $200 in cash. You take it over, you use the $200 to pay off part of the debt, you still owe the debt-holders $300.

This is why it's important to understand the conceptual theory behind memorizing the formulas (this isn't the first time I've heard firms ask why cash is subtracted).

That makes a lot of sense. Thank you.

"On the other hand, you also get the company's cash. Assume the company had $500 in debt and $200 in cash. You take it over, you use the $200 to pay off part of the debt, you still owe the debt-holders $300."

I didn't think that the buyer actually uses the seller's cash to pay down the debt. The reason why you deduct cash in the EV calc is because the buyer does not assume the seller's cash (the cash stays in the seller's hands). However, in the Purchase Agreement if there is a post acquisition cash minimum at closing then the buyer will have to pony up this amount. Of course this doesn't mean the EV will increase - just means the the buyer will have to increase its financing costs. Correct me if I'm wrong though.

When it comes to these kinds of technical questions, you can get very good at them if you find the right resources. Be careful, you don't want to read some finance prof's theory and then use it in an interview. What you want to do is find out what the generally accepted answers are to these questions (you don't want to give a "correct" answer which the interviewer has never heard before).

Thinking of EV as the amount that has to be paid in order to acquire the target is a good approach (e.g., it explains why we use equity value and not market capitalization), but it won't explain why we add minority interest.

Why is cash/cash equivalents subtracted? you should go with b's answer on that one, i've used it before in interviews and its a safe answer.

straight from ibankingfaq.com

"Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a non-operating asset AND (2) cash is already implicitly accounted for within equity value. Note that when we subtract cash, to be precise, we should say excess cash. However, we will typically make the assumption that a company’s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash."

to give you a little more clarity on the previous post (i'm the author of ibankingfaq.com), Enterprise Value measures that value of a firm's operational assets attributable to all providers of capital. the types of capital are debt, equity and preferred stock (though the majority of companies don't have preferred stock outstanding). so we need to aggregate all three of those in the EV formula. cash (tecnically excess cash) is subtracted because it is already accounted for in the market value of equity and it is not considered to be an operating asset. now, most people including most bankers will tell you that you subtract cash because you could use the cash to pay off debt. this is not technically correct, however, since it is what most bankers believe, it is probably a good answer for most interviews (as Niles and B suggest). however, its good to know the real reason as well.

one additional point: in an acquisition, the buyer gets the cash just as the buyer gets all of the other assets, unless negotiated otherwise.

"in an acquisition, the buyer gets the cash just as the buyer gets all of the other assets, unless negotiated otherwise."

If this is the case, the Purchase Price (money paid to the seller) will always be more than the Enterprise Value?

In a cash deal think about what the buyer is paying for. Would you expect a buyer to pay for cash with cash? No.

Marcus: no, but you're on the right track. when we buy a company, we're actually buying the equity. the equity is the purchase price. to calculate the implied Enterprise Value i add the equity purchase price + debt (which we inherit) - cash (which we also inherit). so, normally EV will be higher than the purchase price as long as debt > cash.

let's think about an example: let's say we determine fair market value of the operations of a company is $1 billion. this means that we believe the Enterprise Value is $1 billion. Now, let's assume that the company has $0 debt and $200 million of cash. What would we pay for the equity (what is the purchase price), assuming we buy it at fair market value? We'd pay $1.2 billion. We're paying $1 billion for the operations and $200 million for the cash. The Enterprise Value based on the purchase price is still $1 billion. In this example, the purchase price is greater than the EV as you mentioned (but only because debt is less than cash).

Now, let's assume same transaction except that the company also had $500 million of debt. Now what is the purchase price? $1 billion EV - $500 million debt + $200 million cash = $700 million. EV is still $1 billion so here, EV is greater than the equity purchase price.

To mm3812: not sure exactly your point as the consideration (cash vs. stock) doesn't matter. The important point is that if you're buying cash (that is to say, if there is cash on the seller's balance sheet) then you pay exactly dollar for dollar for that cash (cash=cash). You don't pay a multiple on cash.

Does that help?

wait, so in the enterprise value equation do you add net debt to the EV or subtract it?

the equations above say you add it, but in the calculation ex-banker does, he subtracts it. quite frankly, i can't figure out why it would be added from a logical standpoint (ie a firm with 200 mil of debt should be worth less than a comparable firm without it).

xqtrack: EV=Equity+Debt-Cash or equivalently, EV=Equity+Net Debt. What I was doing was solving for the equity value. Using simple algebra, Equity=EV-Debt+Cash. Note, I assumed preferred and minority interest=0.

thanks...i realize it was a pretty stupid question, but i appreciate the help.

so whats the best way to answer this question in an interview?

Thanks for answering that Genghis.

So basically, what it costs to own that house is the 500K equity value?

And if you pay the ENTERPRISE VALUE (of 800k), you are essentially purchasing the house, and at the same time changing the capital structure (to all-equity)?

no... not right at all... another certified clown!