Enterprise Value
If company raises debt, the cash increase offsets the increase in debt, therefore the Enterprise Value will stay the same. But how come the Equity Value stays the same? What about the higher interest expenses and principal repayments associated with more debt?
Edited
While I agree that debt will not directly affect EV, the interest payments associated with maintaining said debt will impact the share price and equity value.
The reason why equity value doesn't immediately change is because interest payments don't start when debt is taken out; rather, they start in the next period and the most current income statement may not reflect them yet.
That's what I thought as well. But wouldn't the share price immediately discount any changes in the future cash flows to equity which would lead to change in Equity Value?
Thanks for the post. But about the share price itself? If you raise the debt, I assume that we would have higher interest expenses which would lowered the net income and potential dividends to shareholders. Also cost of equity would go up as you increase the debt in the capital structure. Shouldn't then the Equity Value change by a certain amount as well?
Unfortunately, you can't simply say what is going to happen to the equity value. When we say 'Enterprise value (EV) won't change' we mean that there is no substantial impact. E.g. debt and cash more or less offset each other. Corporate finance theory is very extensive in this field and there are tons of theories that mention what could happen to your equity value.
First off, the MM theorem states that the financing decision of a firm does not affects its value... hence if you raise debt, your EV will stay absolutely the same. The MM obviously does not hold in practice due to taxes, imperfections, transaction costs etc. I still think it is useful as line of reasoning.... if you say the intrinsic value of the firm is determined by the future unlevered free cash flows, the financing decision should not impact the value of the firm (assuming you WACC won't change --> perfect capital market).
That said, it is proven that the financing decision of the firm does impact the value of the firm. Easiest example is that interest is tax deductible. Furthermore, remember that cost of debt is lower than cost of equity, so a healthy amount of debt can (and does) increase the value of (most) firms.
If raising debt (and leaving the cash on the BS) does change the equity value depends on a lot of items. For example, the company could have raised the debt now due to favorable market environments because it anticipates to need the cash later and expects interest to rise. The company could have also raised the debt to pay out capital to shareholders. On the other hand, the debt might be used for some (possibly) wasteful investments. So, without knowing what the debt is used for, you cannot say whether the additional interest expense will lower your equity value.
Related to the topic that we don't know why the company raised debt is the market anticipation. So, what does the market think the reason for the additional debt is. There are a few theories in this regard.
For example, the signaling hypothesis suggests that raising debt is a good signal. The reason is that management commits to future regular interest payments and debt payments, which suggests that the firm has a positive view of the future.
On the other hand, the agency theory would suggest that issuing debt (if not really needed for anything specific) can reduce the value of the firm. The reason is that managers are likely to use these funds in a wasteful manner. Thus, not maximizing the value of shareholders.
Sorry if this got quite long. The point I wanted to make was that there is no clear answer as to where the equity value will go (up or down). In more simple settings you can assume that it does not change as the equity value is supposed to represent the real value of the firm. If this question comes up in interviews, assuming that the equity value does not change is a reasonable assumption to make. You can just say ".... assuming equity value stays unchanged, your EV does not change either because cash and debt offset each other.'' The point the interviewer wants you to get is that EV is generally not (or little) affected by your financing decision. You can always elaborate later that the effect on equity value depends on a ton of aspects. Furthermore, keep in mind that the theories above can be expanded substantially and are simplified.
This really helps. Thanks a lot for taking the time to explain it properly, appreciate!
Confusion about Enterprise Value (Originally Posted: 07/01/2014)
got it
errr i mean p/b=1 not bvps
Also for example say company A market cap = 1 and company B Market cap = 1 but company B has debt=1 how is B enterprise value=2.
How is B worth more than A? Shouldn't B be worth less?
also assuming p/b=1 why would someone pay 100 instead of 50? How is the takeout value 100?
You need to rethink your question and ask it in a way that makes sense.
One way you can think of enterprise value is that it equals the market value of operating assets. If you got rid of half of your operating assets, you would end up reducing your enterprise value.
Enterprise Value Question for Fellow Monkeys (Originally Posted: 08/17/2014)
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Curious to see responses for #3. Would equity value fall too, since the company doesn't have the cash anymore?
The answer to #3 is $25. Think of it this way. The asset side has cash of $25 and other assets with a market value of $25 (we will assume it's book value is the same as market value for simplicity). That's how the market value of equity in your example equals $50. If you pay out $25 as cash dividends, you would have $25 in other assets, which will also equal the value of your equity and your EV in this case. Also, the dividend will reduce equity value because you just gave someone else $25 in cash. This is the reason we observe a price drop on the ex-date.
The answer to #4 is $125. You start off with $25 cash and $25 in other assets. You then add $100 in assets from a new investment, which presumably you would have paid for at a fair price (i.e., you raised $100, paid $100, and got an asset worth $100). Therefore, the market value of your equity is $150 [= $25 cash + $25 other assets + $100 new assets]. The mechanical calculation of EV would yield $125 [=$150 market value of equity - $25 cash].
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