Enterprise Value interview question
Company A has a Market Cap of 500m, Debt of 700m, and Cash of 200m. What is EV ?(1Bn) Okay, now the company uses all cash on hand to buy back debt at .50 on the dollar. What happens to EV / Walk me through what happens
Ev is 1B, EV stays the same because financing activities doesnt affect EV
EV should use market value of debt, right? So EV is 500+350-200=650=500+150 post buyback
Enterprise value = market cap + net debt (which is debt-cash + equivalents)
You have existing 500 market cap, and cash goes down 200 and hence debt goes down by 100 bc it's 0.5 on the dollar. Hence new enterprise value = 500+600=1100
you're buying debt for 50 cents on the dollar meaning you can retire $400 worth of liabilities using $200. It seems you're using the reciprocal of the ratio when retiring $100 of debt with the $200 cash.
EV stays the same - all cash used to reduce debt down to 300M, market cap increases to $700M. This is assuming the market wasn’t previously correctly pricing the debt if it was the initial enterprise value should be re-evaluated
Bruh how is market cap changing???
Because the EV necessarily stays the same - company now has less debt because they were able to buy debt back for .50 on the dollar for $400M of debt = $200M savings = 200M increase in market cap.
Original EV = 500 + 700 - 200 = 1000. Now the debt is trading at 50 cents on the dollar, so you can retire $400 of debt using $200 of cash. That would make the EV = 500 + 300 = 800
Now you could argue that since the firm was initially in financial distress that the market value of debt should have been used to calculate the EV. But by that same logic you could say that the equity should be worthless if the debt is trading at such a discount. So I ignored the market value of debt when calculating the EV.
The commenter saying this is a "financing" decision. I see it more as an investment decision. PE firms do this with portcos to boost IRR if the debt is trading at a discount.
I’ll try: seems the issue here is people misunderstanding financing activities doesn’t impact EV vs cap structure changes (not)/impacting EV
When you use 200m cash to purchase debt at 50c on the dollar, aren’t you essentially erasing 400m of debt (=200/0.5) based on market values? You should then have 300m left because I don’t see the question mentioning the entire 700m trades at 0.5$ on a $. EV is then 500m+300m.
On your B/S I don’t think debt is marked to market. In that case it’s only -200m both on cash and liabilities side.
Northshore20 is correct.
EV doesnt change. Market cap goes up by 200 because you somehow managed to reduce debt at 50 cents on the dollar.
does that flow through the IS when you retire debt below book value? I recall reading something about that could be wrong though.
Otherwise I can see that the value of the firm's operating assets logically hasn't changed, so market value would step up to fill the $200 hole caused by decreasing $400 of liabilities with $200 of non-operating assets (cash). Prior to the repurchase, the equity holders would have "missed out" on $400 of cash when the debt matures since debt holders have priority, and now they were able to reduce that by $200. So it makes sense that the $200 savings would accrue to them.
Correct, you recognize a 200 gain on retirement of debt on the IS which increases equity
Edit: some numbers were off as I went off memory and mixed some items up, theory is the same.
Some key assumptions to iron out. Assume $500M of debt is face value, not market already pricing at $0.5/$1. Assume equity holders don't know this payoff is possible.Basically, you have to assume this information is not priced in at all. If we assume no outside forces, then the same rules as always apply. EV can't be destroyed or created by cap structure unless an outside force causes a mispricing (ie. Tax shields, etc). Thus $700M debt is paid to $300M face value debt, which doesn't change the balance of any assets on the book balance sheet. Thus, equity is created. Equity increases from $500M to $700M as the total capitalization hasn't changed (assets are still worth what they are worth in terms of cash flow generation).The reason this question is confusing is because of a simplifying assumptions we make on the market value balance sheet. We typically assume in the EV calc that debt = face value. In theory, if you priced your EV based on marked to market debt, this would have already been reflected. I haven't seen (in my personal experience) EV calculated based on marked to market debt, but I guess technically it's not wrong as long as you have factored in prepayment penalties/all cash flow associated with paying it off today and you have the ability to actually pay it off early.At the end of the day we have the confidence in the sum of EV because we can DCF/multiples into an EV. So it's agnostic to cap structure. Always always always remember that and you shouldn't make any dumb mistakes.
Enterprise Value is unchanged. Equity Value increases to $700mm.
You need to remember the core definitions of equity value and enterprise value. Aswath D (NYU Professor) has a great article explaining this (“A tangled web of values)
I like to thing in balance sheet format. Assets = Liabilities + Equity. So equity value = market value of assets - Market Value of Debt. Assets are further broken down into core operating assets / non core assets (cash).
To begin, the business has total assets of $1,200. Core assets (enterprise value) of $1000, and $200 of cash. Subtracting the $700 of debt from $1200 assets gets you $500, which is the equity value (value of all assets after paying off debt).
The company then spends $200mm of cash to erase $400mm of debt. So assets are now $1000 ($1000 core assets (Enterprise Value) + $0 cash.
Now, the firm only has $300 of debt. So the equity value is now $700. Enterprise Value is $1000, and did not change.
Let me know if this helps. Again, aswath D has a great article that helped solidify this concept for me.
This is theoretical, assumes market was not pricing the debt at the discount initially.
Why does the initial EV take the debt at face value if it's trading at 50? Shouldn't the EV already be down to 650 and the transaction is 1:1 balanced across the cash and debt? Saying the company buying back debt changes market cap feels like it's the tail wagging the dog if you're saying EV is what the market values the company's assets at
Take a step back without using formulas:
1. None of this changes the underlying operating profitability so EV shouldn’t change.
2. Buying back at a discount creates value for equity holders which would get reflected in market cap.
EV is unchanged. The debt repurchase would be -200 Cash, -400 Debt, +200 SE from the gain on retirement. Equity value would now be 500+200=700
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