Interview question about enterprise value
Hi all, just finished an interview and was stumped by the following question.
"I have two buildings, building A and building B. Both have the same cash flows, same risk profile and are in the same country. However, building A begins operations on January 2024 while building B begins operations on January 2025. If I were to value both these buildings today, would there be a difference in valuation?"
I originally thought building A would have a higher valuation given the time value of money and that cash flows for building A were discounted earlier. However, the interviewer seemed dissatisfied with my answer.
He then went on to ask which building would have a higher multiple on June 2025 if we were to use LTM EV/EBITDA, which he provided at the end that building B's multiple would be twice that of building A's, given it only had 6 months of EBITDA, hence implying that EV for both buildings were the same.
I was confused with this interview question:
1) Why does time value of money play a factor in deciding the valuation of the two buildings?
2) Why is the EV of both buildings the same, despite the fact that on June 2025, building A would have half a year's worth of future cash flow less than building B?
Thank you.
You value the businesses as a going concern. In theory, both businesses are identical and produce exactly the same financial profile, so their EV is the same. As long as you can believe that as a going concern, both businesses will continue to exist and be identical and produce identical cash flows, they are worth the same, regardless of whether one started earlier than the other. Hope this helps.
Shouldn’t the first building have higher retained earnings/cash from the first year of operations, and thus higher EV?
Good question. Generally in M&A you assume cash gets wiped out and debt gets refinanced at close, so it's a non-factor.
Thanks for the input. But I was thinking from a DCF using unlevered free cash flow persepctive, at June 2025, wouldn't building B which has more cash flow in the future and hence when finding the PV of all these cash flows, the DCF would show a higher valuation for building B then building A?
A DCF is a very academic way of approaching valuation. That's not to say it doesn't have its uses. It's just not exactly the most applicable in the context of M&A where the value of a business is generally determined by what people will pay for it (comps), and cash/debt gets wiped out/re-financed at close. For the sake of argument, if you did use a DCF, the periods that you're modeling are projected periods only (not any historical periods), so again, the values of the businesses would be the same so long as you could believe that as a going concern, all else equal, they would both produce [$1mm] of cash flow a year.
Question 1: Company A would have higher valuation today because cash flows start one year earlier.
Question 2: They would have same EV because they both are identical moving forward, and the future is what matters in valuation. In response to your other comment, the cash held on a balance sheet doesn’t impact enterprise value.
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Thanks for the input
I'm not sure if I am understanding it correctly, but the two answers sound contradictory. How is it possible for both buildings to have differing valuation for the first part, but then the same valuation for the second part?
In addition, for the second answer, if the future is what matters, then shouldn't building B which has more future cash flow than building A have a higher valuation?
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