Enterprise Value & Debt
Trying to get my head around Enterprise Value and what it means in relation to debt (ignore title, not Aso).
I understand that increasing debt should not make a company more valuable and therefore EV should not increase. But using the below analysis EV increases with debt and all else being equal.
Should equity value be reduced if there is more debt? Any answers appreciated.
Scnr 1 Scnr 2
Mkt Cap 500 500
PLUS: Debt 200 500
(SUBTRACT:) Cash 350 350
EV 350 650
If you raised 300m of debt should have +300m of cash therefore EV doesn’t change
Correct, while the above EV equation is not necessarily wrong, it’s important to address where the cash proceeds are being deployed (in both scenarios, but let’s focus on scenario 2) - the company technically raised 300 more in debt vs. scenario 1, but if cash is still 350 it would imply that the cash has been deployed somewhere useful (an operating asset), which justifies the higher EV. Otherwise, cash is up by the requisite proceeds from debt issuance and EV is unchanged.
Does this work the same way with Equity? What would happen to EV and Equity Value when firm issues 200m of Equity
There's multiple ways to raise equity, but let's say you raised 200mn of equity through a rights offering or a secondary offering. Generally, a rights offering could mean a company is very cash-strapped and finding a way to raise more money.
But the problem with this is that public stocks are liquid/volatile and therefore equity value (market cap) can often change a non-trivial amount over the course of just a few minutes or hours.
So it kind of comes down to how shareholders are pricing in this new information. But putting everything aside and pricing in only the fact that more shares are issued and will have a dilutive effect, market cap shouldn't move because the stock price will decrease to offset the dilutive effect (because more shares are splitting up what is left of the company after paying down its liabilities). So equity value/market cap won't change but the company has more cash, so enterprise value should decrease.
Financing activities don’t affect capital structure (in theory)
They don't affect EV (in theory). They affect capital structure in both theory and reality. If you raise debt you're changing the cap structure.
Think of equity as what's left over after the debt is paid.
So if (as in your example) two businesses have the same equity value, but one business is able to achieve that equity value with a lot more debt ahead of it, then it's a more valuable business overall.
How would the company with more debt be considered more valuable? The companies are equal in EV yet one has a much higher Equity Value due to having less debt, shouldn’t that company be considered more valuable?
I said they were equal in equity value, not EV.
Youre correct that if they were equal in EV, the one with more debt has lower equity value. Thats a different scenario.
If equity value is the same it would be a larger company having more assets given the higher debt. If that doesn’t make sense you can think of buying the company with more debt is more expensive given the need to pay off the debt in the transaction
Raising debt also increases cash, so net debt (Debt - Cash) stays the same. EV remains unchanged.
If you use that cash to buy assets (assume they are operating assets), then EV should be higher for scenario 2. Think of it as how much do others have to take over the company? Even if you pile a billion dollars of debt, if you don't use the cash raised, EV is going to be the same (think of it as you can just pay down the debt with the cash; you're not going to buy cash with cash).
Scenario 1 and 2 are not the same because scnr 2 implies the company used 300 of that extra cash somewhere, likely to buy assets.
Securing debt implies an increase to the cash balance (A = L + E), which would imply no change to EV. In most cases, if a company were to raise debt, their cash balance would increase accordingly. However, if you were looking at a special situation in which there was an unexpected need for a company to raise debt and spend that cash immediately (not refinancing an existing loan but actually spending that amount), there likely be some (likely negative) market reaction as equity holders are now further down the cap stack.
Seconded.
An interesting note that equity starts to price like a call option in distressed scenarios for public companies and can therefore be modeled by the Black-Scholes equation.
In probably all public company scenarios (assuming enough liquidity...), and especially in distressed scenarios like the one aw.ib talks about, the price of a share represents how individuals are valuing the company. Now, there's oftentimes a degree of uncertainty to this, but enough trading by market participants at least gives us a ballpark of where people are valuing the company at.
Mapping out the scenario aw.ib is talking about, pretend ShitCo's Term Loan A is trading at 70 and Term Loan B at 30. Clearly equity holders are 99% not getting anything if the company files for Chapter 11, but the small bit of optionality leaves equity at, let's say, $0.10 per share with 1000 shares outstanding (Market Cap = $100). Say Oaktree, which holds some Term Loan Bs decide to lend $50 more to ShitCo because they think management can turn this company around and would rather have that than file. ShitCo's CEO spends that immediately. But holding all else equal, there can still be multiple reactions to this:
A. The company is now believed to be more likely to survive due to this new cash-> Stocks trade up to $1.00 and EV increases due to Market Cap increase and debt increase
B. The new cash barely does anything, but stock price doesn't move because before and after equity holders will still get no recovery in bankruptcy (and prospects don't change for the company) -> EV up $50
C. The CEO spends it on a lavish dinner or maybe pays himself a fat bonus (sometimes does happen for a lot of these distressed companies although there is clawback for Ch11...)-> More debt, but stocks trade $0.5 to account for less optionality due to the dumb CEO so EV balances out
D. Stock just trades down to $0.1 because equity holders are still on a selling craze -> EV down
Probably not the answer OP wanted but just some interesting scenarios that are a bit oversimplified but should be enough to illustrate how expectations can change Market Cap (always volatile) for a public company, leading to rapid EV changes.
Think of enterprise value as a snapshot of a company’s total value, similar to the bill you receive at the end of a meal at a restaurant. It represents what it would cost to buy out the entire company. You would have to buy out common shareholders, pay off long-term debt holders, buy out preferred shareholders
And buy out any minority or non-controlling interests. You can offset these costs with any cash the business already has within. It can also be thought of as total value of the company as a going concern, beyond just its tangible assets. It’s the sum of the ownership interests and the claims on the company’s assets from both debt and equity holders. It’s also independent of the company’s capital structure as the other commenters alluded to.
MBA asos smh
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