Hi - we have following discussion among partners
You have a Company A with
ENV = 50 (= ENterprise Value)
C = 10
D (bank) = 15
EQV = 50 + 10 - 15 = 45 (=EQuity Value)
Now the owner of company A has learned something about finance and does a smart move: she/he makes her/his customers pay advance payments and does that consistently. That way a permanent cash excess is being created of 5, bringing the cashlevel to 10+5 = 15.
New situation of company A
ENV = 50
C = 10 + 5 = 15
D (bank) = 15
Advance payments from customers = 5
Hypothesis 1 : EQV = 50 + 15 - 15 = 50. Here the advance payments are not deducted from the ENV because they represent a permanent operating financing that is continuously renewed, each time a new customer is paying an advance, replacing an "old" customer. Moreover advance payments do not have to be repaid, provided the products/services are actually delivered. The free cashflow advance payments provide stays within the company. This delivers an excess cash that could be paid out to shareholders and hence increases the equity value of company A from 45 to 50.
Hypothesis 2 : EQV = 50 + 15 - 15 - 5 = 45. Here the advance payments are deducted. The reasoning is that a company cannot add EQV by obtaining permanent free financing from its customers, permanently increasing its (extra) cash level. Therefore the debt of the advance payments should be deducted from the extra cash the advance payments create.
Could someone provide us the answer?
Winsight
This is private equity 101: sustainably reducing working capital equals value creation.
Critical remark: why would customers start paying sooner/in advance? Answer: only when they get a discount.
But think of inventory: reducing that by 5 gives same valuation result.
Accountant will actually do an analysis of working capital last 3 years on a weekly basis to see if your are manipulating w/c position
I think it can be negotiable, depending on the nature of the business. Accounting theory means that an 'unearned revenue' liability is created. I've seen that be considered as a 'debt-like item' in DD. Especially if that cash will be needed to fund the working capital needs of the project that was pre-paid..
Fire that accountant. Growing the business results in cash-in from these advanced payments. It’s a current liability, non interest bearing, and if sustainable % of sales over time this should be part of working capital. If it is above the sustainable level, it is a debt-like.
You're using a faulty premise in each of your hypotheses that ENV would be unchanged by a permanent reduction in working capital. And you should look at ENV as a function of EQV, not the other way around.
Market value of equity is increased, but by how much is complicated.
Assume the extra $5 is immediately paid as a dividend to equity holders. Through a DCF lens, this would be +$5 at t=0, so an immediate increase of exactly $5. However, this is now a slightly riskier business than it was before, because it has a $5 increase in working capital liabilities. In theory, this could impact its borrowing rate on existing debt and/or slightly increase the discount rate used for its valuation, which would slightly offset the $5 increase in valuation. In practice, that offset might be negligible.
Or you could assume the extra $5 was used to pay down debt. This would mean no immediate cash impact for equity holders, but reduced interest payments going forward. Again, increase in value to shareholders, but can't say exactly how much.
The only scenario where equity value wouldn't change is if management kept this "excess" cash on the balance sheet without returning it to shareholders, paying down debt, or investing it in growth (which also creates value). Leaving it on the balance sheet implies its not "excess" cash at all, so it's still essentially working capital.
Short answer: EQV increases to
I could agree with you but then we both would be wrong.
And you should look at ENV as a function of EQV, not the other way around. Most companies are not listed, so we start with ENV as its the result of our DCF. Equity value is ENV minus financial net debt but also debt-likes such as working capital adjustments, one-off provisions, etc.
In theory, this could impact its borrowing rate on existing debt and/or slightly increase the discount rate used for its valuation This is not going to move the needle. Maybe slightly less collateral for the bank, but with customers paying in advance I will never have a default again -> less risk.
Or you could assume the extra $5 was used to pay down debt. This would mean no immediate cash impact for equity holders, but reduced interest payments going forward. Again, increase in value to shareholders, but can't say exactly how much. Wrong again. Paying down debt DOES impact your WACC (as you should use actual gearing to determine the company's value at this moment, not some sort of hypothetical peers gearing). Actually WACC would go up due to the fact you repay debt, so EV effect is +5 minus a bit due to increased discount rate. If you do an APV and seperately value the tax shield, the value of the tax shield decreases in this option.
The only scenario where equity value wouldn't change is if management kept this "excess" cash on the balance sheet without returning it to shareholders, paying down debt, or investing it in growth (which also creates value). Leaving it on the balance sheet implies its not "excess" cash at all, so it's still essentially working capital. Wrong again. Apple has massive amounts of cash on its B/S. Do you really think people dont include that in their valuation?
Short answer: he is right EQV will increase to something between 45 and
Jesus. Slow down, Cowboy.
Sure, there are plenty of times where it's useful to arrive at equity value after arriving at enterprise value. Here, it is not. The question is what happens to equity value? Any attempt to solve this through the impact on ENV is just an extra unnecessary step.
Good point about customer defaults. But my point stands that, all else equal, lower net working capital amplifies the cyclicality of a business. It's not just about the impact on collateral. The more working capital there is, the more it becomes a source of cash in a stress situation with declining revenues. This matters to lenders. This is a theoretical exercise, and I can't quantify this from a hypothetical any better than you can quantify the impact of reduced customer defaults.
"so EV effect is +5 minus a bit..." Assuming you mean enterprise value, you're ignoring the debt payment, which immediately reduces EV by $5. Equity value, even assuming sub-optimal capital structure and increased WACC, still goes up but an uncertain amount, as we both said.
You need to rethink your Apple analogy. Of course Apple's B/S cash counts in its equity valuation. The cash counts here as well. That's not the question. The question is: what happens if Apple's receivable's suddenly and permanently transformed into cash? The only way that impacts equity value is if investors think Apple will one day do something with that cash that they couldn't have otherwise done with A/R. If they never plan to return it to stakeholders or use it to grow the business, then its assumed to be required operating cash, ie working capital instead of "excess" cash (this is why the Enterprise Value formula technically uses debt less excess cash). Moving working capital from one bucket to another won't impact eqv.
[quote="Rover-S"] Short answer: he is right EQV will increase to something between 45 and
Hi fellows -
thanks to your response, we gained more insight, thank you!
I have one other question, following the remark:
And you should look at ENV as a function of EQV, not the other way around.
In school, I learned to derive any variable in a function, without thinking if they were meaningful.
e.g.: A=B+C => B=A-C => C=A-B
In my economics course, I learned about dependent and independent variables. For instance: the produced quantity of a product is dependent on the availability of raw materials to produce it.
In that regard, Given : ENV = EQV - C + D => EQV = ENV + C - D Question : do both equations have sense? Or only one?
Depends on your valuation method. Multilpes, LBO and DCF will provide you with ENV. Listed companies market cap is the start of EqV to which you need to add other equity instruments, financial debt and debt-like items.
Sellers are mainly interested in EqV as that is what they receive. If the only difference would be net debt, it would be such an issue, but debt-like items are much trickier (how to value a potential legal claim, environmental claims, pension fund deficits, warranty claims, low levels of net working capital at any given moment in time, etc etc).
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