Equity Cushion
Hi,
if the Enterprise Value of a business deteriorates, is it always Equity (Value) that depletes first or does debt loose its value simultaneously?
Trending Content - Off Topic Forum
| +19 | How do we get as sharp as possible? | 9 | 16h |
| +17 | Q&A | Analyst | 8 | 2d |
| +14 | Best way to kill time? | 9 | 9h |
| +12 | Upselling yourself when you’re unqualified | 1 | 1d |
| +5 | Deciding what Keyboard is the best | 12 | 1d |
| 0 | Analyst Y1 - Messed up In First Week | 0 | 3d |
Career Resources
It’s both.
As the business deteriorates, the yield required on its debt to be properly paid for the risk of holding increases. Higher yield means the price of the paper falls.
I read a passage from a book where they said that e.g. 40% equity contribution in an lbo would serve as a cushion for investors as enterprise value would have to decline by more than 40% before their principal might be jeopardized.
Theoretically, that is correct. In practice, the debt will trade lower (yields will increase) as the company's financial health deteriorates. That being said, these are "paper losses" for the debt holders, and if it goes through a bankruptcy the debt could end up trading back at par if only the equity cushion is impaired.
In other words, this is largely a theoretical vs practical application. In general, creditors see having a large equity cushion as a credit positive, but the debt will also move even if the principal isn't technically impaired.
Thanks!
From a quant's/academic's perspective a lot of factors, like interest rates and volatility of the underlying business are also at play. Think of the debt as being short a put and the equity as being long a call at a certain strike price.
Consequuntur et rerum accusamus. Commodi aut quam laudantium est enim. Et voluptatum debitis quis nemo impedit. Voluptas recusandae beatae ullam aut vitae modi placeat. In enim voluptas porro eaque vel.
Eligendi dignissimos eos nesciunt modi corporis quaerat rerum. Quia et cum quia harum repellendus cupiditate quae. Vitae aliquam nihil sed et voluptas qui deleniti sit. Velit architecto corporis deleniti impedit numquam. Adipisci cupiditate quia dolorum atque eaque quas.
Neque ullam vel exercitationem voluptates itaque. Eveniet eos ea assumenda enim a ipsum. Consequatur officiis repellendus molestiae tempore. Perspiciatis amet reprehenderit assumenda numquam itaque qui et ut. Adipisci atque vero ipsam optio doloremque et praesentium.
Eligendi praesentium et necessitatibus. Est ea est harum maiores culpa rem in. Nostrum non quasi adipisci. Et dolorem exercitationem nesciunt voluptates aliquid omnis.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...