Capital structure brainteasers
Dear all,
I have a few cap structure brainteasers I wanted to consult you on. Is my reasoning sensible?
Also, could you please share any other similar brainteasers. Thank you.
Number 1
You have a company with a Market Cap of 100 and Net Income of 10.
• First question – what is your P/E Multiple?
o Simple answer: it is just Market Cap / Net Income, 10x
• Assume the company issues 40 in Debt. Instead of keeping the proceeds, it pays them out as a
dividend to shareholders. What is your P/E Multiple now? [This is where I get slightly confused about div'ing the shareholders and buying them out completely]
o Since you took the 40 of Debt and paid out Equity holders, essentially all you did was
swap Equity for Debt. That means your EV stays at 100 (Debt 40 and Equity 60)
o How does your Net Income get affected? Since you now have 40 in Debt, you will
have to pay interest on that Debt. Assume an interest rate of 10%, so your EBT is
reduced by 4 and your Net Income is reduced by tax rate * interest payment. If tax
rate is equal to 50%, your Net Income is reduced to 8
o For the new P/E Multiple, take 60/8 = 7.5x
- Does this appear reasonable? "Size of the pie does not change, only the relative size of D/E slices"
• What has to happen for the two multiples, before and after issuing Debt, to remain the same?
o Your variable factors are the amount of Debt (which is fixed in this case), the tax rate
(which is not changeable) and the interest rate, which is the only thing you could
change
o You want the equation 10 = 60 / [10 - (40 * r * 0.5)] to hold, so r = 20%
o Note: this means your after tax of debt, which is (1 – 0.5) * 20% = 10%, is equal to
your cost of equity, which is Net Income / Market Cap = 10 / 100 = 10%
Is this correct reasoning?
Number 2
A company has a P/E Multiple of 10, with Net Income of 10. The company has no debt and
no cash on hand and is considering an issue of debt in the amount of 50% of its market cap. If
the proceeds are paid out as a dividend to shareholders and if the P/E Multiple remains
unchanged, how much value has been generated? Tax is 30% and interest 7%
• At time 0, the P/E Multiple is 10x, Net Income is 10 and hence EV = Market Cap is 100
• After the issuance, which is going to be 50, the P/E Multiple remains at 10x
• However, Net Income has been affected by the interest payment, after-tax cost of debt is 0.07
* (1 – 0.3) = 0.049 ≈ 5%
• Interest is then 5% * 50 = 2.5, and Net Income will be 10 – 2.5 = 7.5
• On a P/E Multiple of 10x, that implies that your Market Cap will be 10 * 7.5 = 75
• From the perspective of the shareholder, he now owns 75 in Equity and received 50 in Cash,
making the total value 125
• The value created is 25% (= 125/100 – 1)
1
P/E - 10 Issue 40 in debt = dr cash, cr debt; issue dividend - dr retained earnings, cr cash. Assuming 25% tax rate, 10% interest rate, AT interest of 3 (40.75.1) -> PF NI = 7 -> assuming no change in market cap, PF P/E = 100/7 = ~14x No, this is a little odd as typically you'd expect the equity value to fall because paying out a cash dividend, while good for investors, is not a great sign for the long-term since you'd otherwise invest the cash in the business. Equity would have to fall to 70 to keep P/E the same.
Issuing a cash dividend doesn't effect equity value directly, you're not changing share count and would only indirectly change the share price. Your EV is 100 before you issue the dividend but it's 100 equity, 40 debt, 40 cash so it actually goes up to 140 after the dividend but equity and EV should go down once share price settles (likely still above 100 though due to signaling/behavioral finance) which implies that EV/EBITDA expands a bit likely due to closer to optimal capital structure, lower WACC, etc.
2 is correct though it's important to note that equity value falls but the 50 cash dividend creates shareholder value.
Doesn't equity value fall when you issue out dividends? At least that's what I remember learning from the M&I Guides
Also if EV stays at 100 after debt issuance - shouldn't the split be 40 debt and 60 equity like the original poster mentioned? I hoped everything I've been learning isn't wrong
That is my issue - I am quite confused now...
If the proceeds from the debt are used to pay out dividends, then equity value will fall. The other way to think about it is that by paying dividends, you are taking value out of the company and giving it to shareholders. The dividend did not generate any value for the company (as opposed to spending it on capex for example), therefore it's simply a transfer of value from debt holders to equity holders.
The cap structures would be: Currently - EV 100, equity 100, debt 0, cash 0 (0 net debt) Right after raising debt - EV 100, equity 100, debt 40, cash 40 (0 net debt) After paying out $40 in dividend - EV 100, equity 60, debt 40, cash 0 (40 net debt)
Sunt aut voluptates deserunt reiciendis. Nesciunt illum non dolor eum necessitatibus cupiditate. Reiciendis dolorem eaque quas ipsam non. Qui debitis aspernatur quod laboriosam.
Possimus et et saepe ducimus ipsam. Et molestiae molestias veritatis hic ad. Dolorem earum eum debitis at minus laudantium est. Voluptas aliquid pariatur deserunt cum.
Voluptatem ea quidem dolorem voluptatem et ducimus dolor. Expedita enim saepe ab aliquid eveniet excepturi laborum. Quia fuga voluptatum sunt animi dolorem aut. Inventore eius tempore voluptatem velit qui. Alias ad non eveniet iusto.
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...