IB interview question - What happens to enterprise value when...?
Hi guys,
I've recently had a series of EV questions thrown at me during one interview and wanted your opinion whether I've answered them correctly... They all had to do with what happens to enterprise value when you issue new equity or debt. The questions were:
If the current EV of a company is US$500mm, (equity value = US$300mm, net debt = US$200mm, other EV items assumed to be zero) what happens to EV when...
1) ...the company issues US$200mm in new equity?
2) ...the company issues US$200mm in new equity which US$100mm will be used to pay out as dividends to shareholders?
3) ...the company issues US$200mm in new equity which will be used to invest in a business worth US$100mm?
4) Please answer the above if US$200mm in new DEBT is raised (assuming TAX FREE world).
5) What would happen to question 4 if taxes are now involved?
I answered as below:
1) EV is still US$500mm because the US$200mm in new equity will offset US$200mm increase in cash
2) EV is now US$600mm because there is a net increase of US$100mm in equity (US$200mm in new equity minus US$100mm in dividend payout in cash)
3) EV is now US$700mm because the US$200mm cash raised through the equity will be offset by the purchase price of US$100mm (paid in cash) and gain in EV by US$100mm. Effectively, you have US$200mm in new equity, US$100mm in investments and US$100mm in cash remaining.
4) Exactly the same answers as the issuance of new equity answers
5) Didn't know how to answer this one properly ...
Any thoughts as to whether I answered the above correctly?
Not sure how you reconcile 1
Not sure how you reconcile 1 and 2. With the logic from 2, the answer to 1 should be 700 but then again I don't much about EV. I'm just using accounting principles
Genetic wrote: Not sure how
Not sure how you reconcile 1 and 2. With the logic from 2, the answer to 1 should be 700 but then again I don't much about EV. I'm just using accounting principles
2 Should be 500 as well. Think of it in two steps:
1) Company raises 200mm from equity issuance; EV stays constant at 500mm because you have +200mm equity value and +200mm cash in the EV equation, resulting in no change.
2) Dividend of 100mm, so cash down 100mm and equity value also down 100mm
Note: I make the assumption of efficient markets (i.e. in the real world, issuing $X dividends will drop share price by approximately but not always exactly $X).
Issuing dividends will cause
Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.
socola2003 wrote: Issuing
Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.
You are wrong. Please don't post misinformation, and perhaps brush up on your own asset pricing knowledge.
"When a dividend is paid, several things can happen. The first of these is what happens to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades. For most dividends this is usually not observed amidst the up and down movement of a normal day's trading. However, this becomes easily apparent on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34."
Read more: http://www.investopedia.com/articles/stocks/07/div...
A dividend has to be paid
A dividend has to be paid from somewhere, so ultimately it'll reduce shareholders equity through a reduction in retained earnings, leading to a lower equity value.
One of the reasons for dividends sometimes leading to an increase in share price is much like the Apple effect of mutual funds getting hold of something they once couldn't touch, or the various signalling properties of dividends which are grounded in market phycology rather then financials.
Oreos wrote: A dividend has
A dividend has to be paid from somewhere, so ultimately it'll reduce shareholders equity through a reduction in retained earnings, leading to a lower equity value.
Isn't that just book value of Equity though?
"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger
sounds like homework to me
sounds like homework to me
"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.
socola2003 wrote: Issuing
Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.
you can be a arrogant douche when you are right, your just an arrogant retard now xD
In a theoretical, tax-free
In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value. In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.
With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.
I am certain of answers #1-#4. I am open to opposing thoughts on #5.
The answer to questions 1 and
The answer to questions 1 and 2 is the same: $500mm. When equity is issued, the company receives cash in the same amount that equity is increased on the balance sheet. The increase in cash offsets the increase in equity when calculating EV, leaving you with the original amount of $500mm. The second question simply assumes that a dividend is issued right after the scenario in question 1 takes place. So, the $500mm EV company issues $100mm in dividends, which reduces its cash account by that amount, but also reduces shareholder equity by the same. You wind up back where you started once again, with an EV of $500mm.
Now, let's go through the acquisition scenario in question 3. The company (acquiror) gains $200mm in cash from the equity issuance, bringing us to $500mm in EV--just like in the other scenarios. However, in this case, immediately after the issuance, the acquiror spends $200mm in cash to acquire the target. To make things simple, assume the target company has zero equity value, zero cash, and $100mm in debt (the mix doesn't actually matter). The cash paid to the target fully pays down the target's debt, so zero debt, zero cash, and zero equity are added to the acquiror's balance sheet (note, assets will be adjusted significantly, including the goodwill account, due to the excess in purchase price over the target's pre-acquisition value--but that doesn't affect the EV discussion). Thus, the pro forma EV of the acquiror is the pre-transaction amount of $500mm plus $200mm to account for the reduction of cash paid for the target, or a total of $700mm.
The answer to question 4 is that nothing would change versus your previous answers: the cash raised fully offsets the debt raised when calculating EV in each scenario and nothing changes the outflow of cash to pay for the acquisition in question 3's scenario. In each case, debt is simply being increased rather than equity.
The answer to question 5 is the same as question 4: no change. Normally, interest expense is tax deductible, true. However, this would have no impact on EV at the moment any of the transactions discussed have been effected. Rather, the result would be future increases in earnings and cash flow compared to the same scenarios in a tax-free universe, which will only affect future EV. You would create a deferred tax liability in the acquisition scenario due to the amortization of the intangibles write-up, but that will have no effect on pro forma EV at the time of transaction.
Remember to keep things simple. Enterprise value is nothing but debt, plus equity, minus cash. It is a value at a given point in time. Taxes are expenses that take effect between reporting periods. The excess purchase price paid in the third question is a red herring as well: the excess would be accounted for in an intangibles write-up and new goodwill, and would not matter in the calculation of pro forma EV.
re-ib-ny wrote: In a
In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value.
I honestly have no idea what the "Miller-Modigliani theorem" is, but I don't think you can get away with citing it in an interview. You need to be able to explain your answers in accounting terms.
In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.
This is wrong. The target company was only worth $100mm before the transaction. At the transaction, it suddenly became worth the amount paid for it, or $200mm. Purchase accounting adjustments handle such discrepancies, chiefly through adjustments to intangibles and goodwill. The trick behind question 3 is realizing the difference in pre-acquisition value and purchase price is irrelevant to calculating pro forma EV.
With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.
Again, I think you are thinking too far beyond the scenario. The questions are asking for EV the moment each transaction has been effected. The debt tax shield will have no effect on EV at the time of transaction. The risk of bankruptcy and whether the target is "optimally leveraged" are also irrelevant.
leveredarb wrote: socola2003
Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.
you can be a arrogant douche when you are right, your just an arrogant retard now xD
Boom.
jd-to-ib wrote: re-ib-ny
In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value.
I honestly have no idea what the "Miller-Modigliani theorem" is, but I don't think you can get away with citing it in an interview. You need to be able to explain your answers in accounting terms.
In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.
This is wrong. The target company was only worth $100mm before the transaction. At the transaction, it suddenly became worth the amount paid for it, or $200mm. Purchase accounting adjustments handle such discrepancies, chiefly through adjustments to intangibles and goodwill. The trick behind question 3 is realizing the difference in pre-acquisition value and purchase price is irrelevant to calculating pro forma EV.
With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.
Again, I think you are thinking too far beyond the scenario. The questions are asking for EV the moment each transaction has been effected. The debt tax shield will have no effect on EV at the time of transaction. The risk of bankruptcy and whether the target is "optimally leveraged" are also irrelevant.
JD-to-IB -- In your prior post's explanations to questions #1 and #2 you more or less explain how the MM theorem works in practice. For any finance nerds with time, here's a link to the 1958 paper: http://www.his.se/PageFiles/17648/modiglianiandmil.... Their work, and that of Sharpe and Markowitz, form the basis of most modern theoretical finance.
For #3, you are absolutely right from an accounting perspective. The OP stated that the "value" of the business was $100MM, which I took to mean intrinsic rather than book value. I suppose that is something one ought to clarify in an interview setting. If I were the interviewer, I'd take either answer.
I agree in part and disagree in part with your answer to #5. Again, from an accounting perspective you're right, but from a valuation perspective, capital structure does impact value in a world with taxes. And if I were the interviewer, I would only ask the question about taxes to test whether you understood the valuation concept. Again, basic theoretical finance suggests that the value of a levered firm = value of unlevered firm + PV of tax shields - PV of overhang from financial distress, where the PV of both the tax shields and distress increase with added debt.
Re-ib-ny, I was not assuming
Re-ib-ny, I was not assuming the pre-transaction value of the target company in question 3 is book value. Actually, whether the pre-transaction value is intrinsic, market-based, or book, is wholly irrelevant to pro forma enterprise value in an acquisition scenario. The only thing that matters is the amount paid. This is true from both an accounting and theoretical perspective, as actual value trumps inferred value any day.
Anyway, what I described is how you would model the transaction as an M&A banker, which is what matters to the OP.
As for question 5, delevering and relevering a company, then adjusting for the present value of tax shields and financial distress, is yet another attempt at inferring an intrinsic value of a company in place of calculating its actual value in a specific context. While you're at it, you could also run two different DCFs based on the given capital structure using two different tax rates (zero versus whatever rate you assume for the question). I guarantee you, this is not what the interviewer is driving at.
Here's why: we are given the actual market value of equity to actual shareholders, the actual value of debt to actual debt holders, and the actual value of cash on the balance sheet. We do not need to infer anything on financial theory.
The interviewer simply wants to see how well the OP understands the concept of enterprise value in conjunction with basic financial accounting.
I think our disagreement lies
I think our disagreement lies in how you interpret "worth" in the OP's post. If the target is in fact "worth" $100MM to the acquirer, as the OP suggests, then the acquirer purely engaged in a value destructive deal. I suppose you could assume in this theoretical world that all parties are rational actors and that the $100MM delta in "worth" vs the $200MM takeover consideration is justified by synergies. I went with the opposite assumption that it was a value destructive deal.
I would, however, like to clarify my answer. The $100MM dilution that I mentioned in my first post is dilution to existing equity holders. Enterprise value increases by $100MM (if you assume my value destructive deal) or $200MM as JD-to-IB notes (if you assume JD-to-IB's rational actors).
To your contention on #5, we are given the "actual market value of equity" PRE-TRANSACTION. The post-transaction value of financial instruments can be impacted by capital structure. If the business were over-levered to begin with, then an increase in debt mix would increase the WACC, therefore reducing the value of the firm.
For a much more knowledgeable
I apologize for the