Few questions for a newbe
Hi all,
I have a few questions on which I'd like to be sure I understand well the concepts, maybe someone could help me ?
If I add 100 debt on a company, its Entreprise value will not change, right ? (since 100 debt is 100 cash for me, so net debt will not change)
Same question if I use this debt to buy a plant : the value will increase by 200, right ? EV = Equity (+100 due to the plant) + Debt (+100) - Cash (+100 -100)
It seems wrong but I can't see why :(
Also, I have a problem with this EV concept. Entreprise Value is the price someone would pay to buy my company. And the more cash I have, the more the price decreses ??
EV = Equity + Debt - Cash (to keep it simple)
If I have no debt, all the cash I generate reduces the price of my company ?? I get it that if you buy my company, you will have the cash for you and that's as if you didn't pay that part of the company (the cash part). Or maybe my ability to generate cash is valued in the equity value ?
In advance, many thanks for you help !!
If you add 100 debt to the enterprise, you don't add cash, you add value. DEBT = DEBT not CASH. Cash is liquid money or assets that can be quickly sold to obtain money (dolars, euros, etc.). This cash is substracted from the EV because they decrease the aquisition price.
In the second case, happens exactly the same. As debt is debt, and not cash, you increase the EV. In this problem there is no CASH, so you have to completely delete it from the formula or just put a zero. Once you get debt you engage into some obligation, but where you derive it, it doesn't matter. The only thing that this investment can create is new revenue for the firm (that of course can increase the NPV of the enterprise, but that's another problem).
The EV is not the price someone would pay to buy your enterprise. It's just a measure of valuation. Yes, cash always reduces it since it can be thought of it as a way of reducing debt. Remember that debt increases your EV but you will have to return it someday. That cash can help you to repay it, which consequently reduces EV.
Yes, it reduces it because EV is subject to future cash flows. Money doesn't by itself produce future cash flows, you have to invest it. When you invest you create something that can generate, in theory, future "benefit". When you want to valuate an enterprise, you want to know its capacity to produce "income". The fact that today has X millions doesn't mean tomorrow is going to if the enterprise has no future plans of doing something.
For more info, check out this thread: //www.wallstreetoasis.com/forums/why-subtract-cash-when-we-calculate-enterprise-value
***PS. oh and now that I think about it more, your first sentence doesn't make much sense, and I'll tell you why. Let's say you are correct, and that added 100 debt is cash. The EV wouldn't keep unchanged, in fact, it would decrease EV. Look at the formula you've written.
FYI it's spelled newbie
Thanks a lot for your detailed answer. I must be missing something, how can debt not turn into cash ?
I go to the bank an contract a loan, the bank gives me cash. So my debt increase by 100, but so does my cash. Isn't it how it works ?
Before I walk into the bank : EV = E + D - C = 2000 + 0 - 0 = 2000
When I walk out of the bank : EV = 2000 + 100 - 100 = 2000
When I buy a plant with the 100 : EV = 2000 + 100 = 2100 at least, if we consider that this asset has no impact on my 2000 equity.
Thanks for the linked topic btw, I think I get the concept of "- cash" now. It's like buying a bill :)
You have to stop thinking like a normal person, and start seeing things as a finance professional.
For a normal person it would happen as you describe: you go to a bank and obtain money, so money=cash. But in finance things don't work exactly like that. I don't know how to explain it in a very simplistic way, but imagine debt is a paper where you put a number. Then with that paper you buy the plant. Morgages work like that in some way, you bought the house but you never saw the whole amount of money... however each month you have to pay. This model is wrong but you can get at least what I mean.
Btw I've seen that you're an intern, could you tell me which is your backround? I mean degree.
You're welcome :) ... as long as it helps then cool.
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