Hi - we have following discussion among partners
You have a Company A with ENV = 50 (= ENterprise Value) C = 10 D (bank) = 15 EQV = 50 + 10 - 15 = 45 (=EQuity Value)
Now the owner of company A has learned something about finance and does a smart move: she/he makes her/his customers pay advance payments and does that consistently. That way a permanent cash excess is being created of 5, bringing the cashlevel to 10+5 = 15. New situation of company A ENV = 50 C = 10 + 5 = 15 D (bank) = 15 Advance payments from customers = 5
Hypothesis 1 : EQV = 50 + 15 - 15 = 50. Here the advance payments are not deducted from the ENV because they represent a permanent operating financing that is continuously renewed, each time a new customer is paying an advance, replacing an "old" customer. Moreover advance payments do not have to be repaid, provided the products/services are actually delivered. The free cashflow advance payments provide stays within the company. This delivers an excess cash that could be paid out to shareholders and hence increases the equity value of company A from 45 to 50.
Hypothesis 2 : EQV = 50 + 15 - 15 - 5 = 45. Here the advance payments are deducted. The reasoning is that a company cannot add EQV by obtaining permanent free financing from its customers, permanently increasing its (extra) cash level. Therefore the debt of the advance payments should be deducted from the extra cash the advance payments create.
Could someone provide us the answer?
Winsight
You're using a faulty premise in each of your hypotheses that ENV would be unchanged by a permanent reduction in working capital. And you should look at ENV as a function of EQV, not the other way around.
Market value of equity is increased, but by how much is complicated.
Assume the extra $5 is immediately paid as a dividend to equity holders. Through a DCF lens, this would be +$5 at t=0, so an immediate increase of exactly $5. However, this is now a slightly riskier business than it was before, because it has a $5 increase in working capital liabilities. In theory, this could impact its borrowing rate on existing debt and/or slightly increase the discount rate used for its valuation, which would slightly offset the $5 increase in valuation. In practice, that offset might be negligible.
Or you could assume the extra $5 was used to pay down debt. This would mean no immediate cash impact for equity holders, but reduced interest payments going forward. Again, increase in value to shareholders, but can't say exactly how much.
The only scenario where equity value wouldn't change is if management kept this "excess" cash on the balance sheet without returning it to shareholders, paying down debt, or investing it in growth (which also creates value). Leaving it on the balance sheet implies its not "excess" cash at all, so it's still essentially working capital.
Short answer: EQV increases to $50.
Jesus. Slow down, Cowboy.
Sure, there are plenty of times where it's useful to arrive at equity value after arriving at enterprise value. Here, it is not. The question is what happens to equity value? Any attempt to solve this through the impact on ENV is just an extra unnecessary step.
Good point about customer defaults. But my point stands that, all else equal, lower net working capital amplifies the cyclicality of a business. It's not just about the impact on collateral. The more working capital there is, the more it becomes a source of cash in a stress situation with declining revenues. This matters to lenders. This is a theoretical exercise, and I can't quantify this from a hypothetical any better than you can quantify the impact of reduced customer defaults.
"so EV effect is +5 minus a bit..." Assuming you mean enterprise value, you're ignoring the debt payment, which immediately reduces EV by $5. Equity value, even assuming sub-optimal capital structure and increased WACC, still goes up but an uncertain amount, as we both said.
You need to rethink your Apple analogy. Of course Apple's B/S cash counts in its equity valuation. The cash counts here as well. That's not the question. The question is: what happens if Apple's receivable's suddenly and permanently transformed into cash? The only way that impacts equity value is if investors think Apple will one day do something with that cash that they couldn't have otherwise done with A/R. If they never plan to return it to stakeholders or use it to grow the business, then its assumed to be required operating cash, ie working capital instead of "excess" cash (this is why the Enterprise Value formula technically uses debt less excess cash). Moving working capital from one bucket to another won't impact eqv.
That was a whole lot of calling me wrong to arrive at the exact same conclusion.