Is Cash a non-operating asset
M&I400: Question 8 on EV vs Equity says that cash is subtracted from EV because it's considered a "non-operating asset." This seems highly counterintuitive. Can someone please explain?
M&I400: Question 8 on EV vs Equity says that cash is subtracted from EV because it's considered a "non-operating asset." This seems highly counterintuitive. Can someone please explain?
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Cash is non-operating because it does not do anything to produce revenue. Think about examples of operating assets like machinery, equipment, etc. Those assets create the products a business sells, cash does not.
Furthermore cash is included in equity value, which is a component of enterprise value. So, if you failed to subtract cash from EV you would be double counting cash.
How is cash included in equity value?
Think about what equity represents: claims to the assets of a company. Within assets is cash. So cash is included in equity value. Hope that helps.
Companies have minimum cash requirements aka cash required to fund operations. Excess cash, isn’t an operating asset though. Say a company hasn’t been paying out dividends and it operates in a very low capex industry, cash that flows into retained earnings doesn’t get spent and the cash balance grows. So the company is left with tons of cash that isn’t necessary for their day-to-day operations
This goes back to Modigliani-Miller. Enterprise value measures the value of the enterprise (meaning it’s operations) independent of its cap structure. The idea is that you cannot adjust cap structure to change the market value of equity unless there are tax advantages, etc. (in a vacuum it’s impossible to engineer value).
There are two types of cash: cash used in operating activities and excess cash. The market value balance sheet only deals in excess cash. Primarily because operating cash is considered required to generate the cash flows of the business so in theory the value of that cash is baked into the PV of future cash flows. Which makes sense because if you pulled that cash out, the purchaser would have to put it back in to generate the projected cash flows. Then the purchaser would be willing to pay the PV of future cash flows minus the additional investment of cash needed to generate those cash flows. So we consider any cash needed for operations to be included in the PV of future cash flows.
Market value balance sheet:
EV + Excess Cash = Gross Debt + Market Value Equity
We can restate market value BS as:
EV = Gross Debt + Market Value Equity - Excess Cash
Gross Debt - Excess Cash = Net Debt
So EV = Net Debt + MVE
For example, you have a business that has $5M of cash on its BS. It needs $1M of cash to operate, so $4M is Excess cash. It’s MVE is $70M and it has $34M of Gross Debt.
In order to produce a $70M valuation, you need that $1M of cash. So the seller has a choice: leave $1M cash in the accounts and sell the asset for $70M or dividend it out which reduces the value to $69M (because in order to produce a $70M valuation, the purchaser has to put $1M into the investment on day one). Say our seller decided to leave the $1M in the accounts so the valuation remains $70M.
Our MV BS is as follows:
EV + $4M Excess Cash = $34M Gross Debt + $70M MVE
Or EV = $30M Net Debt + $70M MVE
The enterprise value of the operating entity is $100M. The value of the equity (what someone would pay to acquire the shares) is $70M. That means our buyer would pay no more than $70M for this enterprise. However, the seller has $4M of excess cash on the entities books not considered in the market value of equity.
Now our seller has a choice. They can either dividend $4M to themselves (get the cash off the balance sheet) which shareholders may not like because it triggers income taxes. In this case, the buyer would pay $70M for the equity in this business. Or… they can leave the cash on the BS and include it in the sale price. How much would you charge to sell cash? One for one. Our seller elects to not piss of shareholders by making them pay income tax and leaves it on the books.
So the buyer is getting a business capable of producing future cash flows with a PV of $70M. They are also getting $4M of cash not needed to produce the future cash flows. The buyer would pay $74M to acquire the equity share in this business.
To round out Modigliani-Miller: The PV of all future equity cash flows includes any and all capital deployment assumptions and yields a $70M valuation. The seller could borrow $50M today and all that this would do is become cash since you’ve already accounted for all capital deployment opportunities and you have your $1M of operating cash. So you have future cash flows worth $70M, you had excess cash of $4M before and now you have $54M. The purchaser would pay $70M+$4M+$50M. The enterprise value equal $34M+$50M-$54M+$70M or $100M. Levering did not add any additional equity value or enterprise value (in a vacuum with no tax implications).
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