Enterprise value question - A bit confused
I'm currently studying for CFA level III and going through some valuation concepts for upcoming interviews, and I'm a bit confused with some of the notions surrounding enterprise value. In Breaking Into Wall Street's IB interview guide, it says the following:
"If you say that Debt “adds to” Enterprise Value, you’re implying that raising Debt can change a company’s Enterprise Value – which is not true!"
Ok, so from what I understand, if a company raises $100 of debt, its cash balance increases by $100. So the net effect on EV is 0 (since Debt increases EV by 100 but then cash decreases EV by 100).
But what if the company immediately buys fixed assets (machinery or whatever) with the cash immediately. From my understanding, the EV would increase by $100, since debt increased by $100 and cash did not increase (because it was immediately used to buy equipment). Is my reasoning correct?
Did you ever hear about MM propositions?
Yes. I'm simply trying to confirm whether or not buying fixed assets with debt would affect EV under the following simplified EV formula, regardless of MM:
EV = Debt + Common Equity + Preferred Equity - Cash & cash equivalents
If you would care to actually elaborate on your point and clarify that for me, it would be helpful.
What do the propositions state?
What is MM?
Miller Modigliani
maximum mustache
Moglidiani & Miller
Thanks.
Yeah as you say I guess it's easier to see the CAPEX as going into operating assets that will generate revenues. Thanks for the response
I think yours is the best answer. Effectively once the cash is invested then the EV should move initially based on the projected value creation of the investment (the company's cash flow profile changes) and in the long run based on the actual performance of that investment (which could also be value destructive if things go south).
"If you say that Debt "adds to" Enterprise Value, you're implying that raising Debt can change a company's Enterprise Value - which is not true!"
This statement is actually wrong because it does not specify the time horizon. At the exact time of the debt raise indeed the EV does not change. However, the debt raise proceeds must be used for something and those actions will eventually alter the company's EV.
For these type of questions I think it's always better to think about the company's business from first principles: Enterprise Value as the value of the company's core operations (which is also why we make adjustments for equity interests and non-controlling interests). So when you raise $100 of debt and get $100 in cash, none of those items actually affect a company's operations.
But when you spend that cash to buy fixed assets, the 'value' of the company's operations increase by $100. So yes, in that case, the EV would increase by $100.
Let's say the company used that $100 in cash to buy a 9.9% equity interest in another company. The EV here would not actually increase, despite the cash being used, because again it does not affect the company's core operations.
This is incorrect. The 9.9% equity interest is an operating asset that will bring extra income/cash flows into the enlarged group and hence the EV would change.
Alternatively, think about it this way. EV represents the total amount someone has to pay all stakeholders to acquire the company. Saying that the EV would not change after the company acquires a non-core equity interest in another company implies that the potential buyer would get the non-core equity interest for free which is not the case. It is not about whether the asset is core or non-core it is about whether the asset is operating or not.
Dude - you're spending way too much time on one question. Goal is to pass the exam which as you know is 6 large textbooks worth of material, so try to be as efficient as possible with your time.
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