I get why EBITDA is capital structure neutral because interest costs aren't figured in. But EV adds debt to market cap so a company with a lot of debt would have a much higher EV/EBITDA ratio than another company with the same characteristics other than high debt. It sounds like the opposite of capital structure neutral?
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Equity value + debt - cash. Increase in debt is offset by subtracting the cash raised. Enterprise value does not change.
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I literally asked myself this moments ago
Haha. When you have a Wall Street forum that is most heavily populated with freshmen in college who don’t know anything more than the guide they memorized, “inaccurate” ms gets thrown around often.
Going off my original post, a better way to illustrate that it’s capital structure neutral is this way:
Equity value: 300 Debt: 150 Cash: 20 Enterprise value: 430
Now a company raises an additional 100 of equity to pay off 100 debt.
Split into 2 separate events: the equity raise and the debt pay down
Equity value: 300+100= 400 Debt: 150 Cash: 20+100=120 Enterprise value: 430
Now for the paydown
Equity value: 400 Debt: 150-100 =50 Cash: 120-100= 20 Enterprise value: 430
As you can clearly see, all of these “events” have no implication on enterprise value.
Hey man,
However, if we look at it from a DCF perspective - discounting our FCFF by WACC to obtain our enterprise value.
Taking on more debt due to the tax benefit will actually lower our WACC before bankruptcy costs sets in. Discounting the same set of cash flows with a lower WACC would lead to a higher enterprise value.
So is enterprise value capital structure netural? Would appreciate some clarification :)
Finance theory (Modigliani-Miller Theorem) simplifies the real world so that a firm’s value is independent of its capital structure.
In this same regard, you probably simplified your WACC’s beta of debt to be 0, but that’s also not true in the real world.
A company w/ a lot of debt would not have a much higher EV/EBITDA ratio. For that to be true, the cashflows available to equity holders would have to be the same regardless of debt, and that's not how debt works.
It's sometimes helpful to think of EV/EBITDA by considering the alternatives. Would you look at EV / earnings per share? Probably not, because EV includes debt, and interest/principal payments to lenders have been paid before you get to EPS. How about equity value / EBITDA? Again, no, because EBITDA reflects all cash flows available to all sources of capital, and if your numerator doesn't include lenders, you're going to distort what equity holders really have a claim on.
Because it is how the business is valued regardless of how it is financed. What you do with the cash to settle up with stakeholders after EBITDA is up to the firm.
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