How does Enterprise Value change when Debt-to-Equity changes?

Hey guys!

I've been confused lately by the way experts interpret the way Enterprise Value changes when Debt-to-Equity ratio changes.

Some of them say that since D/E changes, tax shields are expected, so EV is going up.

But if you think of it this way:
D/E going up drives Beta(levered) to go up. Higher Beta leads to higher cost of equity, which also makes WACC higher. Since WACC is becoming higher, EV goes down.

This may be a simple question for some of you guys out there, can you please shed some light on it?

Thanks!

And a small follow-up:

Do we calculate WACC using D/E or D/V (where V = Enterprise Value, i.e. D+E), because I've seen both versions?

 

WACC = [D/E * r(debt) * (1 - t)] + [(1 - D/E) * r(equity)]

take a partial derivative of WACC wrt D/E and get:

dWACC/d(D/E) = [r(debt)(1 - t)] - r(equity) = r(debt) - r(equity) - r(debt)(1-t)

Since under normal circumstances cost of equity is more than the cost of debt, [r(debt) - r(equity)] WACC, and therefore a same-direction change in EV (as dEV / dWACC

 
Best Response

More simply put, it depends. Each dollar of debt has a lower cost than equity due to the benefits of the tax shield. Each dollar of debt however, also increases the company's risk of bankruptcy.

Up to a certain point, an additional dollar of debt will lower one's WACC and effectively maximize its EV. Beyond that point however, an additional dollar of debt threaten's the company's livelihood and the prospect of bankruptcy outweighs the benefits of the tax shield. Thus, the WACC increases and EV decreases. The theoretical optimal capital structure is the point which minimizes the cost of WACC.

If you want to learn more look up the static theory of capital structure.

 
evergumptious:
More simply put, it depends. Each dollar of debt has a lower cost than equity due to the benefits of the tax shield. Each dollar of debt however, also increases the company's risk of bankruptcy.

Up to a certain point, an additional dollar of debt will lower one's WACC and effectively maximize its EV. Beyond that point however, an additional dollar of debt threaten's the company's livelihood and the prospect of bankruptcy outweighs the benefits of the tax shield. Thus, the WACC increases and EV decreases. The theoretical optimal capital structure is the point which minimizes the cost of WACC.

If you want to learn more look up the static theory of capital structure.

I just gave out my last SB but you answered his question beautifully: Optimal/Capital Structure

Here to learn and hopefully pass on some knowledge as well. SB if I helped.
 

Aliquid consectetur a magnam quisquam vel id. Dolore ut natus alias natus dolores recusandae. Repellendus magni natus corporis perferendis voluptatem et sint.

Quibusdam accusamus veritatis aliquam illum est. Enim voluptatum quibusdam recusandae perferendis architecto. Aut at voluptatem et.

Amet eligendi ipsam nobis sit. Rerum recusandae ipsa at.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
Secyh62's picture
Secyh62
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
BankonBanking's picture
BankonBanking
99.0
5
kanon's picture
kanon
98.9
6
CompBanker's picture
CompBanker
98.9
7
dosk17's picture
dosk17
98.9
8
DrApeman's picture
DrApeman
98.9
9
GameTheory's picture
GameTheory
98.9
10
bolo up's picture
bolo up
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”