Hi team,
I had an interview today and got a question that still confuses me a bit
"You're selling a company for 10x multiple, what would be more beneficial/ have bigger impact:
- EBITDA increase for 1 dollar
- Net Working capital decrease for 10 dollars"
So if you are selling for higher EBITDA, you will have $10 higher EV. The decrease in NWC will increase your free cash flow (10+x, x is from EBITDA increase- that will boost our free cash flow), and also increase your cash balance (inventory down, cash up). But cash up will reduce enterprise value as it is a non-core asset. Could someone help me connect the dots here, what am I missing? Or is my logic above wrong?
Further, is there a thread or somewhere where I can test my skills on similar questions.
It is funny because in the real world, at least with manufacturing businesses, the net working capital is usually pegged in the SPA to a set dollar amount reflecting a normalized level. Any net working capital amount over the peg at closing results in a dollar for dollar increase in the purchase price paid. An underage results in a dollar for dollar decrease in the purchase price paid. The seller has to provide a preliminary schedule of unaudited net working capital balances as of a few days before closing. The buyer then has to validate the balances presented and can dispute the number a few months after close if it has a material disagreement with the preliminary net working capital level. Upon resolution of the dispute by the means prescribed in the SPA, any difference between the preliminary and final closing net working capital balance is then repaid to the buyer (assuming the buyer would not dispute the balance if their calculation requires a payment to the seller).
Note that in the foregoing scenario, the seller does not lose money when net working capital decreases pre-closing because they get the benefit of the cash generated. They just have to pass that cash on to the buyer, so there is no net effect.
As far as this question goes in an interview context, if the seller actually gets to keep the cash from the decrease in NWC instead of effectively passing it on to the buyer through a decreased purchase price, that provides $10 of value to the seller.
A $1 increase in EBITDA increases the enterprise value of the business if a constant 10x multiple is applied by $10. For simplicity's sake, let's assume this EBITDA increase occurs because we are adding back a $1 non-recurring expense that the buyer fully agrees should be excluded from EBITDA. The buyer should thus be willing to pay $10 more for the business. The $10 benefit directly increases the equity purchase price because net debt is unchanged.
Thus, you should generally be indifferent between the two scenarios. However, it is important to understand what exactly is being asked. There could be more nuance depending on how it is posed. For example, if we are looking at this from the buyer perspective when analyzing historical data, decreases in net working capital are generally not recurring cash flows whereas EBITDA usually is. Accordingly, if an increase in FCF in the prior year is driven by higher EBITDA, that suggests a higher valuation impact than an increase in FCF driven by a decrease in net working capital. I am almost certain that is not what is being asked, but it just goes to show how stupid these questions are that it can be so unnecessarily confusing.