Hey was going through practice and saw this question on a website.
So if EV is the discounted value of all future cashflows as well as EV = market cap + minority interests + preferred stock + debt - cash what happens if your debt IR goes down?
If we're looking at the formula, your debt interest payments decrease so your cash on hand goes up. Equity value will potentially increase due to market knowing you have additional cash.
What about from a future CF perspective? If interest rate goes down your debt payments decrease and you can pay off more debt. Debt goes down in the future meaning cost of equity and cost of debt decreases right? so your WACC in theory will decrease overall.
The question I have is what will happen to your EV because debt is typically cheaper than equity but you're also paying off more debt so your equity percent in WACC will increase offsetting the decrease in cost of debt and cost of equity. Is the increase in equity relative to debt going to make WACC go up or down?
bump
Not sure you can say that lower interest rates will mean that the company will pay debt faster. Company can have fixed principal payments or lump sum at the end. Regarding wacc, lower interest rate means that wacc will be lower, but if debt is paid down, then at one point wacc will increase because the equity portion will be higher and cost of equity is more expensive. It can go either way, too much or too little debt will decrease firm value.
You're drawing conclusions here that aren't appropriate.
No it doesn't. Cash on hand is a balance sheet item that wouldn't be immediately affected.
Equity value will absolutely increase, but not because the firm all of the sudden has more cash. The firm will still produce the same amount of cash going forward, but less will be required for debt service and more will be available for equity holders. This expectation of higher FCFE will increase the market value of equity.
You could pay off more debt because you're generating more free cash flow, but you wouldn't necessarily. In fact, you just demonstrated that debt is now even cheaper than it was before. If anything, that would point management towards shifting its capital structure towards more debt, not less.
Immediately, equity value increases and all other variables stay the same, so EV increases. Eventually the company will make adjustments to its capital structure, but you should not assume that just because it theoretically can pay off more debt, that it will.
My take is: that the yield on debt decreased because market value of debt has increased, thereby giving you a higher enterprise value.
The Debt portion of the EV calculation is as recorded on the balance sheet, and is not affected by how it trades on the secondary market.
It took me a while to think through this so, please don't think I'm trying to be argumentative but, my logic goes that the market value of the capital components on the secondary market reflect the present day value of those components and would therefore be a better proxy when looking at the total capital employed by the business. For valuation comparison, I can't see how BV would be as relevant as MV. I see your point though that BV better reflects the one-time cost of taking out that capital component.
Debitis qui qui et est eum eaque. Est eius est harum sunt qui est ut dolorem.
Officia voluptatem eius saepe nulla consequatur eum velit. Est quo autem aut. Eligendi error qui quisquam enim nisi. Sapiente vel natus harum et ducimus. Tempore vel omnis provident ipsum. Ab voluptatibus rerum sint. Enim omnis laudantium in odit.
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...