Enterprise Value - Why do you subtract cash?
I was reading Moyer's and the explanation goes as follows:
The rationale for this is that the decision by the firm to hold cash rather than pay down debt is a strategic financial decision. For example, consider two firms that, for hypothetical purposes, have exactly the same intrinsic EV. The management of Firm X wants to appear to have strong liquidity and thus holds a large cash balance over the quarter-end reporting date. The management of Firm Y wants to show that it has relatively less leverage and thus uses all available cash to pay down a working capital line on the last day of the quarter. If no adjustment for cash is made, Firm Y would appear to have a higher EV even though, per our assumption, they are equal.
Why would Firm Y have a higher EV if cash is not subtracted?
I’m sure someone will disagree with me here but in general the main purpose of EV is to make an adjustment to market cap for the purposes of M&A. This is also why you add in debt, as market cap alone doesn’t capture the true value that an acquirer would pay for. The cash would not be included in a sale, debt would, so you add the debt and subtract the cash and that gives you a very rough estimate of the value of the firm in terms of M&A.
Why would cash not be included in the sals? If you purchase a company that is holding cash, you acquire the cash as well
The idea is that the cash is going to be used to offset whatever debt the company has when the company is acquired, so you add debt then subtract cash.
If you're an analyst in banking you should know this...
bro im in high school. never too early to prep
Bro your flair says you’re an IB analyst.
yeah. i will be
Are you a senior? Please dont say freshman
Lol
The value of a house you buy is $1,000 but inside the house there's a hundred dollar bill just sitting there. You gain $100 after your purchase, so before your purchase you can think of the value of the house as $900.
Thanks that’s a good way of thinking about it!
You need to think of the formula the other way around:
Equity value = enterprise value less debt PLUS cash. The cash is a part of the equity value. When you issue a cash dividend the share price will drop after.
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