Impact of cash dividend on EV in tax free world
The following was a question in one of the IB guides.
Question: In a perfect (tax free) world, if you have a company with an enterprise value of $5bn and you take out $2bn in debt: What is the enterprise value if you subsequently use the $2bn to pay out a dividend?
Answer: Paying out a dividend of $2bn eliminates cash on the balance sheet and, in doing so, eliminates $2bn in equity value. Thus firm value remains the same at $5bn.
I do understand that financing in a tax free world should not impact value of the company, however, I did not understand the provided answer. "Eliminating 2b in equity value from the BS" should not be the right justification because its explaining accounting impact rather than Market value impact.
Thank you
Simplified equation for enterprise value = equity + net debt - cash
I think his explanation skipped a couple steps.
Market value of Equity should not go down with a dividend payment only Book value of equity goes down
Enterprise Value = equity value + Debt - Cash +/-... Cash goes down $2bn and book value of equity goes down $2bn, so EV is unchanged. You can think about why this makes sense several ways. Cash isn't an operating asset, so it shouldn't be included in the firm's value, and as such any changes to cash should not effect firm value. From a buyout perspective, if you paid $5 for the equity of a company with $2 in cash, you are in effect paying $3 dollars. If that firm were to pay that $2 in cash out beforehand, you would only pay $3 for the equity to begin with.
In this perfect tax-free world, book value of equity = market value of equity, so that justification is correct. The question really just wanted to see if you conceptually understand the what makes up Enterprise Value.
I don't think BVequity = MVequity even in a tax free environment. Take the example of a series of equity issuance on different dates with different trading prices: 1. P=$10, #=10 2. P= $15, #=10 Total Book Value of equity =10x10 +15x10=250 Market value of equity = 20shares x current price($15)=$300
I understand the accounting aspect of it and the fact that financing does not impact value, however, I am failing to see how it flows through the EV equation:
EV = MVequity + Net Debt Net debt increased by $2bn, So MVequity should have decreased 2b too in order for EV to stay $5b. However, market value of equity does not decrease with dividends payment. So how did the EV equation yield 5b?
Its still vague for me.
You're overthinking this. The entire point of this "perfect world" stuff is to isolate how a dividend affects value. Equity Value = EV - Debt + Cash -> Equity Value = Firm Value - 2bn debt + 2bn dividend -> pay out dividend -> 2bn dividend is gone, so new equation is equity value - 2bn dividend = Firm Value - 2bn debt
That 2bn in cash is already priced into equity value and when it's paid out, that cash is transferred from the firm's hands to investor's hands, thus decreasing the value of equity in the firm.
Just saw this. Market value of stocks do adjust for dividend payments ...it varies how much and there are other factors at play
In a perfect world if my stock is trading at 10 bucks and you issue a one dollar dividend, the share price should adjust to 9 bucks because for your 10 dollars of equity or claim to the business you got your proportional 1 dollar
In the real world some stocks react more some less to a dividend but if you look on google or yahoo the price after a div is paid adjusts
Read this if you want
http://www.investopedia.com/articles/investing/091015/how-dividends-aff…
Omg so much bad info here
Stock price almost always goes down with a dividend payment...it's simple math...
More than just contributed earnings in BV of equity...
The stock price decreases ex-dividend date period. but returns to its original price afterwards
I would approach the problem remembering that the EV is equal to the value of the CORE business for debt and equity holders. Hence, a dividend payment or debt raise do not change the core business so EV stays the same.
I do understand it conceptually, but I am looking for an explanation on how it flows through the EV equation EV = MVequity + Net Debt if Net debt increased by 2b, than MVequity should decrease by 2b in order for the EV to balance out. So the question is, why does MVequity decrease by 2b?
MV represents the value of the entire company (core and non core) for its shareholders. Since the company paid out a dividend, its non core assets are worth less so MV goes down by 2bln
so after this transaction your net debt is incremented by 2b and decreased by 2b - it stays the same after the dividend issuance Cash is reduced by 2b [so Net debt is incremented by 2b] as does retained equity [MVEQ decreased by 2b] there u go. some guy before said WACC changes in MM. the whole point of MM is that WACC isn't capital structure dependent. http://images.slideplayer.com/15/4519406/slides/slide_13.jpg why not ? MVE = Present Value of future dividends at Time_0. a Div issuance would reduce that.
I think the easiest way to think about this is simply that a divrecap is just a change in the capital structure. You are taking out $2MM of debt to replace $2MM of equity. In the real world this should increase the EV slightly because of the tax deductible nature of the interest, but with the "tax-free" stipulation the EV stays the same because there is no tax benefit from the debt anymore.
There is no change in capital structure when dividends are paid. WACC= WeRe+ WDRD We and Wd represent market values not book values
Actually some practitioners will debate with you whether you use market or book value of that debt - it's a Silver Lake interview question actually
You are basically changing the capital structure. The Modigliani/Miller theorem helps to think about it (as mentioned above). MM basically says that capital structure doesn't affect firm value, subject to the following assumptions: perfect and complete capital markets, no taxes, bankruptcy not costly, symmetric information, and capital structure does not affect investment policy and cash flows.
In this example, in the MM world, there is no change in EV when you change the capital structure. Debt is higher. equity value is lower. Lower because there is more debt "in front" of the equity holders so equity is riskier.
In the non-MM world where there are taxes, equity value could be higher due to tax shields, and note that existing debt is riskier so kd higher.
Note current equity holders were the beneficiaries of the payout. The payout does not itself affect future cash flows so the payout itself won't impact equity value.
Isn't he talking about how stock price reacts to dividends? Book value of Equity and market value of equity are two different things ...
Agree with Mr. Fuld - silver bananas all around! And way to whip out the MM lol
Thx. you mentioned this was a Silver Lake question. do you happen to have some pdf with some witty questions? as an aspiring monkey who hasn't yet found an internship any help is appreciated.
Sent you dick_fuld.
FYI the wacc argument is debatable - some PE guys will use MV. MM is highly theoretical and not a good way of approximating real risk frankly. But in a vacuum yes, it should not change but you also realize for MM to hold true, they don't address MV vs. BV
Of course - MM is subject to completely unrealistic assumptions. It is just a base case and good way to organize thoughts.
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