How / why does Enterprise value change?
I got asked this question and I’m embarrassed to admit that it stumped me slightly. Here’s the question I was asked and the subsequent confusion that arose in my mind
A company issues 100 in stock and 100 in debt in order to buy 100 in PPE and 100 in investments. How will enterprise value change?
Usually I like to answer these questions by analyzing the impact on each component of the EV equation. So, Market Equity is up by 100, Total Debt is up by 100, Investments and PPE are both up by 100. Net change in cash is 0 as whatever cash came in was spent on PPE and investments. Going by the formula, EV = Eq V + Total Debt - Cash - Investments, you can see that EV will be up by 100.
But my question is where will the positive change in PPE be reflected in the EV calculation? Is it not possible that EqValue May increase even more because market may give the investors some credit for potentially utilizing new PPE to increase returns.
What if instead of PPE, we were acquiring a company that had PPE and maybe some liabilities. How would the math for enterprise value change?
If PPE goes up by 100, which here implies capex, shouldn’t EV go down by around 100, all else equal? I’m thinking back to the DCF equation.
This is a good question. A DCF is an intrinsic valuation(your own assumptions) that gives you an implied EV. The equation in the OP is for current EV. Either way in the case of a DCF, your problem is you are assuming that the CapEx doesn't produce future cash flows. For example, ceteris paribus if a company makes a CapEx for $100 in say year 4, then yes UFCF would fall by $100. However, the whole point of a CapEx is to improve operating capacity and efficiency, thereby leading to higher cash flows in the future. This is the idea of capital budgeting and NPV, where you measure the value of an investment by its expected future cash flow contributions and discounting them using time value of money.
Cash flows should increase in year 5 and beyond because of the CapEx in year 4. If it wasn't going to increase cash flows in a worthwhile manner, the company wouldn't have made the CapEx. In terms of certain events affecting EV or EqV, we tend to simplify and make assumptions like perfect markets and rational investors to make the problem easier to do.
The best way to go about EV problems(at least for me personally) is look at how net operating assets(operating assets- operating liabilities) changes. In the OP, stock, debt, and investments are not operating investments. PPE is an operating asset, so $100 worth purchase of it increases EV since there's no change in operating liabilities.
Hope this helps
Well if you issued 100 of debt and held it in cash equivalents there'd be no impact to your EV. Add the 100 from stocks so your enterprise value increased by 100 total. Why do you need your PPE to be reflected here, if that 100 was used for inventory it wouldn't impact your EV so why should PPE impact it? Maybe I'm just not understanding
If it was inventory, EV would still be impacted because inventory is an operating asset. EV is value of net operating assets to all investors, so if operating assets goes up,(assuming no change in operating liabilities) then EV would go up. The only operating asset in this question was PPE, so a $100 purchase of it increases EV by $100.
EV = Equity Value + Net Debt (simplified)
I believe they informed that you spent 100 on PPE and 100 in Investments to let you know that all the "cash" that they raised through financing is used up. Since net debt is debt-cash, this means that the 200 in cash that they raised will not be subtracted in the EV equation so all 200 adds to enterprise value.
This would mean: EV (+200) = Equity Value (+100) + Net Debt(+100).
It would increase 200 I believe. Let me know if that makes sense or if that's wrong
Investments aren't operating assets and are implicitly accounted for by EqV. So when you're moving from EqV to EV, you would subtract investments. Therefore, if you went off the pure EV equation and tried to do the math for each term, EV only goes up by 100.
As I understand it(feel free to correct me if I'm wrong), enterprise value is value of the net operating assets(operating assets-operating liabilities or the core operations of the firm) to all investors(debt, preferred stock, etc.). I find the easiest way to see changes in enterprise value is to ignore the formula for enterprise value and just see if any operating assets or liabilities change. Stock and debt are not operating assets, so these do not affect enterprise value. Investments are also not operating assets. PPE is an operating asset. Since you acquired PPE worth 100, enterprise value rises by 100.
I think the best way to think about your second question is that when the company purchases $100 of PPE, all the investors in the company are now seeing an added value of $100 more of assets in the company. Since EV is the value of net operating assets to all investors, acquiring PPE increases net operating assets and therefore all investors see an increased value in the company.
If you purchased another company(100% stake), enterprise value would increase by the amount of the purchase price(assuming all cash transaction). It doesn't matter what the net assets are of the company you are acquiring because any excess amount paid over the value of net assets would be constituted as goodwill, which is an operating asset. The company itself that is purchased is an operating asset because it obviously helps the acquirer expand its operations. This is of course assuming the company purchased is actually relevant and not a side-business. For example, a software company purchasing another software company. If it purchased an ice-cream company, that would not be related to the company's operations and would not affect EV.
Hey dude Or dudette. You may be write on this but i am hoping that some certified user also jumps in on this and lets me know how to think through this. It’d be nice to get some more validation
Fair enough. Only a prospect so I definitely might be wrong.
Take at look at this M&I guide: https://samples-breakingintowallstreet-com.s3.amazonaws.com/IBIG-04-04-…
Author is definitely reliable and might explain the concepts more clearly than I am.
EV is up 100. Remember EV = Market Cap + Debt - Cash. All cash from the capital raise is used. 100 in additional debt is on the balance sheet. Market Cap is assumed constant. Don't over complicate it.
Public or Private?
Indifferent. How would both change?
Anyone experienced please? I’d love to hear from verified folks
PPE would add +100 to EV. Investments would not have an impact on EV (unless it is core to business). EV could go up >100 if PV of cashflows generated from the PPE is >100.
Thanks for responding. I SB-Ed you.
I’m thinking of a DCF. If PPE goes up by 100, which here is capex, all else equal, wouldn’t EV go down by 100?
Where is PPE accounted for in the EV equation - market equity + total debt - cash and equivalents
I’d appreciate if you could please share some thoughts in this. Thanks
No not necessarily. If PPE goes up by 100 (i.e. capex), that would decrease cash flow in t=0 and have an adverse effect on EV. However, the earnings (i.e. cash flow) potential from the new asset may also be 100 in total during its lifetime (post discounting), which nets out the effect.
No. In your DCF, EV will go up by the PV of the asset. So even if the asset turns out to be worthless and generates no value (i.e., PV =0), EV will remain unchanged. The only way for EV to go down by 100 is if the asset is truly value destructive such that the asset causes the cashflows of the overall business to be lower.
As the EV represents the MV of operating assets, the question would be whether these investments are operating assets or not.
Operating Assets + Non-Operating Assets = Total Equity Funds + Total Debt Funds
Hence EV = MV of Operating Assets = MV of Total Equity Funds + MV of Total Debt Funds - MV of Non-Operating Assets
If they are operating, then the change would be an increase in 200 (+100 from equity and + 100 from debt)
If they are not, the change would be an increase in 100 (+100 from equity, +100 from debt and - 100 from investments, as they are non-operating)
Thank you for asking me to contribute to this thread.
Ok, this is a highly theoretical question. Let's go through it.
When a company issues more equity or increases its debt, there is no change to EV. All the entries you outlined will cancel each other out, so on Day 1 the EV stays the same*
(* There could be a tiny impact on WACC because of changes in D/E proportion)
The interesting part is what happens later on. Theoretically speaking, if the new capital from debt and equity is productively spent on PPE and investments, then the company's unlevered operating cashflows will increase. EV is the present value of all future unlevered operating cashflows. Therefore, EV should eventually increase provided you get a return above WACC on these investments.
If these PPE and investments are uproductive, they are capable of destroying the value of the company. So, if these investments are wasteful, EV can decrease.
Therefore, if the original question is about accounting, there shouldn't be any change. If there was as an easy way to increase EV through capital structure, then every company would be doing it all day long.
If the question is about what happens next after some time, I gave you my perspective.
Good luck,
Tamara
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