The answer is supposed to be that EV increases by \$50 because you are converting a "non operating" asset (cash) to an "operating" asset (PP&E), but I don't really understand the accounting behind this. Could someone please explain in an alternative way?

Comments (23)

Just based on the formulas:

EV = Equity Value - Cash + Debt

Cash went down by \$50 and net assets stay the same so equity value isn't affected. EV goes up by \$50.

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TheEmperor:

Just based on the formulas:

EV = Equity Value - Cash + Debt

Cash went down by \$50 and net assets stay the same so equity value isn't affected. EV goes up by \$50.

I've been asked OP's question before during IB interviews, and this was what the interviewer was looking for.

I had a similar question.

For perspective
https://www.wallstreetoasis.com/forums/how-to-handle-a-terrible *

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Not sure if you guys have it right. Your PP&E investment decreases both your equity and enterprise value.

Let's make an example. Before your company invests in PP&E you calculate an enterprise value of 100 and have a cash balance of 20 (using the discounted cashflow method). No debt on the balance sheet. All this results in an equity value of 120. Now you decide to increase your PP&E by 10. Your enterprise value would decrease by 10 because buying PP&E would result in higher capex which in turn decreases your free cashflows and your calculated enterprise value. Your enterprise value now is at 90 and with a cash balance of 10 (20 - 10) you would calculate an equity value of 100. Altogether, your enterprise value decreases by the amount of your PP&E investment. Your equity value decreases by the double amount of your PP&E investment.

All this assumes, that you increase your PP&E at the beginning of your discounting period (no discounting effect on your capex) and that higher D&A due to a higher asset balance won't affect your cash taxes (which is not always the case).

My calculation would be wrong if you assume that a PP&E investment would increase your free cashflows in the future hence increasing your discounted cashflows and your enterprise value.

Hope that helps...

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I don't agree. You're arguing that using \$10 cash to buy \$10 of property necessarily reduces your equity value on the basis of the impact on a DCF analysis. You base this on the assumption that new PP&E necessarily reduces future cash flow, and therefore changes the equity value of the company. This assumption means that your original DCF analysis was wrong because you incorrectly estimated the future capex needs of the company, which is not the same thing as a assessing if the transaction itself (not the new information you got from it) is changing the value of a company. Apply a sum of the parts method to arrive at equity value and it won't be changed due to the PP&E investment.

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That's why I said the following:

"My calculation would be wrong if you assume that a PP&E investment would increase your free cashflows in the future hence increasing your discounted cashflows and your enterprise value."

I guess my calculation is right as long as the PP&E investment is a replacement. When the PP&E investment was made due to business expansion you have to adjust your future cashflows accordingly.

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Ya but orange you glad he didn't say banana

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Best Response

Let me try to explain in a more intuitive / simple way. Imagine you have a nice wallet (Asset) that you bought for \$500 (Enterprise Value). Then you immediately put a \$100 dollar bill (Cash) in the wallet. What is the value of your wallet now? It is still \$500, not \$600. The value of your wallet doesn't change because you put more cash in the wallet. Said another way, if you were to sell your wallet, you would take out the \$100 dollar bill first before you sell your wallet (Asset).

Now, let say you use the \$100 bill that you had put in your wallet and bought another wallet (Asset) for \$100. Now you have 2 wallets (both assets) worth \$600 (your enterprise value increased from \$500 to \$600). You essentially turned your non-operating asset (Cash) into an operating asset (another wallet).

Make sense?

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This was really helpful, thank you!

The above answers assume that enterprise value is the book value of operating assets. Actually, we should think of EV as the value of operating assets so for illustration EV=(FCF_1)/(WACC-g). EV will increase by the NPV of the PPE, and cash will clearly decrease by 50. So any residual will impact equity if the debt isn't distressed or anything.

There is no change in enterprise value. If you buy PPE then your cash goes down. Your asset book value remains the same. Your liabilities stay the same and so your equity stays the same. Unless the market places a higher value on the PPE than hard cash, your EV will be the same.

exlurker:

There is no change in enterprise value. If you buy PPE then your cash goes down. Your asset book value remains the same. Your liabilities stay the same and so your equity stays the same. Unless the market places a higher value on the PPE than hard cash, your EV will be the same.

This. I've been waiting so long for this comment, thank you.

This misses the point of the question. The question is seeing if you understand why the market would value \$50 in PPE more than \$50 in cash -- i.e., understanding the difference between a non-operating asset and operating asset.

It's not a good question because almost any answer would suffice if the beginning of the answer is "it depends". The mathetmatical answer is that EV doesn't change; it doesn't matter if you change the form of an asset from \$50 of paper to \$50 of machinery. Theoretically, the future value of the PPE should = the future value of the cash used to buy the machinery.

One thing that I don't feel that is being addressed is the future effects of that \$50 investment in equipment. While it does effect the cash balance, which will result in an increase in EV through the equation, you also need to account for how this will affect future equity value. If the market feels that this investment's IRR is greater than the WACC, then this will reflect positively in the stock price and increase equity value.

I was asked this exact question for a super day and when I went over this concept, the interviewer was satisfied with my answer.

That is wrong because any effect on equity value goes through the effect on EV - what you're describing is precisely why EV increases (it increases by the NPV of the asset if markets are efficient). Then, since equity has the residual claim on the company's operations, equity value can change. But if the market thinks the cash flow from the asset discounted at WACC is 50, equity value won't change because you also spent 50, so the size of the pie is the same.