Enterprise Value Interview Questions for Banking

I recently had an interview in which I was asked the following questions. They all had to do with what happens to enterprise value when you issue new equity or debt. The questions were:

If the current EV of a company is US$500mm, (equity value = US$300mm, net debt = US$200mm, other EV items assumed to be zero) what happens to EV when...

  1. ...the company issues US$200mm in new equity?
  2. ...the company issues US$200mm in new equity which US$100mm will be used to pay out as dividends to shareholders?
  3. ...the company issues US$200mm in new equity which will be used to invest in a business worth US$100mm?
  4. Please answer the above if US$200mm in new DEBT is raised (assuming TAX FREE world).
  5. What would happen to question 4 if taxes are now involved?

I answered as below:

  1. EV is still US$500mm because the US$200mm in new equity will offset US$200mm increase in cash
  2. EV is now US$600mm because there is a net increase of US$100mm in equity (US$200mm in new equity minus US$100mm in dividend payout in cash)
  3. EV is now US$700mm because the US$200mm cash raised through the equity will be offset by the purchase price of US$100mm (paid in cash) and gain in EV by US$100mm. Effectively, you have US$200mm in new equity, US$100mm in investments and US$100mm in cash remaining.
  4. Exactly the same answers as the issuance of new equity answers
  5. Didn't know how to answer this one properly ...

Any thoughts as to whether I answered the above correctly?

Investment Banking EV Interview Questions

Enterprise value questions allow the interviewer to test basic accounting and enterprise value knowledge and therefore are popular interview questions. We walk through the answers to the above questions below.

First we review that the simple equation for enterprise value is Equity + Debt - Cash.

Scenario: If the current EV of a company is US$500mm, (equity value = US$300mm, net debt = US$200mm, other EV items assumed to be zero) what happens to EV when...

Question 1: ...the company issues US$200mm in new equity?

  • Equity increases by $200
  • Cash increases by $200
  • Result: $200 + 0 - $200 = no change to EV

Question 2: ...the company issues US$200mm in new equity which US$100mm will be used to pay out as dividends to shareholders?

  • Equity increases by $200 but is lowered by $100 due to the dividend payout
  • Cash increases by $200 - but $100 is paid out to shareholders
  • Result: Equity increases by $100 and cash increases by $100 = no change

Question 3: ...the company issues US$200mm in new equity which will be used to invest in a business worth US$100mm?

User @elephantastic shared a detailed explanation:

elephantastic:

The company (acquirer) gains $200mm in cash from the equity issuance, bringing us to $500mm in EV--just like in the other scenarios. However, in this case, immediately after the issuance, the acquirer spends $200mm in cash to acquire the target. To make things simple, assume the target company has zero equity value, zero cash, and $100mm in debt (the mix doesn't actually matter). The cash paid to the target fully pays down the target's debt, so zero debt, zero cash, and zero equity are added to the acquirer's balance sheet (note, assets will be adjusted significantly, including the goodwill account, due to the excess in purchase price over the target's pre-acquisition value--but that doesn't affect the EV discussion). Thus, the pro forma EV of the acquirer is the pre-transaction amount of $500mm plus $200mm to account for the reduction of cash paid for the target, or a total of $700mm.

Question 4: Please answer the above if US$200mm in new DEBT is raised (assuming TAX FREE world).

elephantastic:

The answer to question 4 is that nothing would change versus your previous answers: the cash raised fully offsets the debt raised when calculating EV in each scenario and nothing changes the outflow of cash to pay for the acquisition in question 3's scenario. In each case, debt is simply being increased rather than equity.

Question 5: What would happen to question 4 if taxes are now involved?

User @elephantastic shared a detailed explanation:

elephantastic:

The answer to question 5 is the same as question 4: no change. Normally, interest expense is tax deductible, true. However, this would have no impact on EV at the moment any of the transactions discussed have been effected. Rather, the result would be future increases in earnings and cash flow compared to the same scenarios in a tax-free universe, which will only affect future EV. You would create a deferred tax liability in the acquisition scenario due to the amortization of the intangibles write-up, but that will have no effect on pro forma EV at the time of transaction.

Learn more about enterprise value below:

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Comments (32)

Mar 29, 2012

Not sure how you reconcile 1 and 2. With the logic from 2, the answer to 1 should be 700 but then again I don't much about EV. I'm just using accounting principles

Mar 29, 2012
Genetic:

Not sure how you reconcile 1 and 2. With the logic from 2, the answer to 1 should be 700 but then again I don't much about EV. I'm just using accounting principles

2 Should be 500 as well. Think of it in two steps:

1) Company raises 200mm from equity issuance; EV stays constant at 500mm because you have +200mm equity value and +200mm cash in the EV equation, resulting in no change.

2) Dividend of 100mm, so cash down 100mm and equity value also down 100mm

Note: I make the assumption of efficient markets (i.e. in the real world, issuing $X dividends will drop share price by approximately but not always exactly $X).

Mar 29, 2012

Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.

    • 2
Mar 29, 2012
socola2003:

Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.

You are wrong. Please don't post misinformation, and perhaps brush up on your own asset pricing knowledge.

"When a dividend is paid, several things can happen. The first of these is what happens to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades. For most dividends this is usually not observed amidst the up and down movement of a normal day's trading. However, this becomes easily apparent on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34."

Read more: http://www.investopedia.com/articles/stocks/07/div...

    • 1
Mar 29, 2012
socola2003:

Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.

you can be a arrogant douche when you are right, your just an arrogant retard now xD

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Mar 29, 2012
leveredarb:
socola2003:

Issuing dividends will cause a stock price to drop? Please re-learn the basics of asset pricing.

you can be a arrogant douche when you are right, your just an arrogant retard now xD

Boom.

    • 1
Jan 4, 2017

Lol...

Mar 29, 2012

A dividend has to be paid from somewhere, so ultimately it'll reduce shareholders equity through a reduction in retained earnings, leading to a lower equity value.

One of the reasons for dividends sometimes leading to an increase in share price is much like the Apple effect of mutual funds getting hold of something they once couldn't touch, or the various signalling properties of dividends which are grounded in market phycology rather then financials.

Mar 29, 2012
Oreos:

A dividend has to be paid from somewhere, so ultimately it'll reduce shareholders equity through a reduction in retained earnings, leading to a lower equity value.

Isn't that just book value of Equity though?

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

Jan 4, 2017

.

    • 1
Jan 4, 2017

Nope, theoretically the market value of equity decreases by exactly the amount of dividends (all else equal in perfect markets).

Now, this isn't true in real life because dividends have different signaling effects (usually positive since it infers a good long-term outlook by the company as dividends are sticky--meaning it's difficult for management to reduce dividends without repurcussions so they only raise/pay them out if they're sure they can maintain it) and investors react differently/have different interpretations. There are a bunch of theories on the different perceived effects.

Ultimately though, in this question, you assume perfect markets and all that--the interviewer just wants to see your theoretical knowledge of accounting/EV principles, so you ignore the real-world events from above.

Mar 29, 2012

sounds like homework to me

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Mar 29, 2012

In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value. In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.

With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.

I am certain of answers #1-#4. I am open to opposing thoughts on #5.

    • 1
Mar 29, 2012
re-ib-ny:

In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value.

I honestly have no idea what the "Miller-Modigliani theorem" is, but I don't think you can get away with citing it in an interview. You need to be able to explain your answers in accounting terms.

re-ib-ny:

In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.

This is wrong. The target company was only worth $100mm before the transaction. At the transaction, it suddenly became worth the amount paid for it, or $200mm. Purchase accounting adjustments handle such discrepancies, chiefly through adjustments to intangibles and goodwill. The trick behind question 3 is realizing the difference in pre-acquisition value and purchase price is irrelevant to calculating pro forma EV.

re-ib-ny:

With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.

Again, I think you are thinking too far beyond the scenario. The questions are asking for EV the moment each transaction has been effected. The debt tax shield will have no effect on EV at the time of transaction. The risk of bankruptcy and whether the target is "optimally leveraged" are also irrelevant.

    • 1
Mar 30, 2012
jd-to-ib:
re-ib-ny:

In a theoretical, tax-free world, the Miller-Modigliani theorem holds, and capital structure and dividend policy are irrelevant. #1, #2, and #4 have no impact on enterprise value.

I honestly have no idea what the "Miller-Modigliani theorem" is, but I don't think you can get away with citing it in an interview. You need to be able to explain your answers in accounting terms.

re-ib-ny:

In #3, enterprise value is diluted by $100MM because the company spent $200MM for something worth $100MM.

This is wrong. The target company was only worth $100mm before the transaction. At the transaction, it suddenly became worth the amount paid for it, or $200mm. Purchase accounting adjustments handle such discrepancies, chiefly through adjustments to intangibles and goodwill. The trick behind question 3 is realizing the difference in pre-acquisition value and purchase price is irrelevant to calculating pro forma EV.

re-ib-ny:

With tax-deductible interest, a firm can theoretically lower its cost of capital (and increase the enterprise value associated with the same stream of unlevered cash flows) by issuing debt. But the benefits are outweighed eventually, when the bankruptcy risk outweighs the tax benefits. Without knowing the cost of debt, and whether the firm was optimally leveraged to begin with, I think it's impossible to answer #5.

Again, I think you are thinking too far beyond the scenario. The questions are asking for EV the moment each transaction has been effected. The debt tax shield will have no effect on EV at the time of transaction. The risk of bankruptcy and whether the target is "optimally leveraged" are also irrelevant.

JD-to-IB -- In your prior post's explanations to questions #1 and #2 you more or less explain how the MM theorem works in practice. For any finance nerds with time, here's a link to the 1958 paper: http://www.his.se/PageFiles/17648/modiglianiandmil.... Their work, and that of Sharpe and Markowitz, form the basis of most modern theoretical finance.

For #3, you are absolutely right from an accounting perspective. The OP stated that the "value" of the business was $100MM, which I took to mean intrinsic rather than book value. I suppose that is something one ought to clarify in an interview setting. If I were the interviewer, I'd take either answer.

I agree in part and disagree in part with your answer to #5. Again, from an accounting perspective you're right, but from a valuation perspective, capital structure does impact value in a world with taxes. And if I were the interviewer, I would only ask the question about taxes to test whether you understood the valuation concept. Again, basic theoretical finance suggests that the value of a levered firm = value of unlevered firm + PV of tax shields - PV of overhang from financial distress, where the PV of both the tax shields and distress increase with added debt.

    • 1
Best Response
Mar 29, 2012

The answer to questions 1 and 2 is the same: $500mm. When equity is issued, the company receives cash in the same amount that equity is increased on the balance sheet. The increase in cash offsets the increase in equity when calculating EV, leaving you with the original amount of $500mm. The second question simply assumes that a dividend is issued right after the scenario in question 1 takes place. So, the $500mm EV company issues $100mm in dividends, which reduces its cash account by that amount, but also reduces shareholder equity by the same. You wind up back where you started once again, with an EV of $500mm.

Now, let's go through the acquisition scenario in question 3. The company (acquiror) gains $200mm in cash from the equity issuance, bringing us to $500mm in EV--just like in the other scenarios. However, in this case, immediately after the issuance, the acquiror spends $200mm in cash to acquire the target. To make things simple, assume the target company has zero equity value, zero cash, and $100mm in debt (the mix doesn't actually matter). The cash paid to the target fully pays down the target's debt, so zero debt, zero cash, and zero equity are added to the acquiror's balance sheet (note, assets will be adjusted significantly, including the goodwill account, due to the excess in purchase price over the target's pre-acquisition value--but that doesn't affect the EV discussion). Thus, the pro forma EV of the acquiror is the pre-transaction amount of $500mm plus $200mm to account for the reduction of cash paid for the target, or a total of $700mm.

The answer to question 4 is that nothing would change versus your previous answers: the cash raised fully offsets the debt raised when calculating EV in each scenario and nothing changes the outflow of cash to pay for the acquisition in question 3's scenario. In each case, debt is simply being increased rather than equity.

The answer to question 5 is the same as question 4: no change. Normally, interest expense is tax deductible, true. However, this would have no impact on EV at the moment any of the transactions discussed have been effected. Rather, the result would be future increases in earnings and cash flow compared to the same scenarios in a tax-free universe, which will only affect future EV. You would create a deferred tax liability in the acquisition scenario due to the amortization of the intangibles write-up, but that will have no effect on pro forma EV at the time of transaction.

Remember to keep things simple. Enterprise value is nothing but debt, plus equity, minus cash. It is a value at a given point in time. Taxes are expenses that take effect between reporting periods. The excess purchase price paid in the third question is a red herring as well: the excess would be accounted for in an intangibles write-up and new goodwill, and would not matter in the calculation of pro forma EV.

    • 4
Aug 13, 2019

Why does it not matter what the cap structure is? For example, were it to be $50 Debt and $50 Equity, how does this result in the same null effect?

Mar 30, 2012

Re-ib-ny, I was not assuming the pre-transaction value of the target company in question 3 is book value. Actually, whether the pre-transaction value is intrinsic, market-based, or book, is wholly irrelevant to pro forma enterprise value in an acquisition scenario. The only thing that matters is the amount paid. This is true from both an accounting and theoretical perspective, as actual value trumps inferred value any day.

Anyway, what I described is how you would model the transaction as an M&A banker, which is what matters to the OP.

As for question 5, delevering and relevering a company, then adjusting for the present value of tax shields and financial distress, is yet another attempt at inferring an intrinsic value of a company in place of calculating its actual value in a specific context. While you're at it, you could also run two different DCFs based on the given capital structure using two different tax rates (zero versus whatever rate you assume for the question). I guarantee you, this is not what the interviewer is driving at.

Here's why: we are given the actual market value of equity to actual shareholders, the actual value of debt to actual debt holders, and the actual value of cash on the balance sheet. We do not need to infer anything on financial theory.

The interviewer simply wants to see how well the OP understands the concept of enterprise value in conjunction with basic financial accounting.

Mar 30, 2012

I think our disagreement lies in how you interpret "worth" in the OP's post. If the target is in fact "worth" $100MM to the acquirer, as the OP suggests, then the acquirer purely engaged in a value destructive deal. I suppose you could assume in this theoretical world that all parties are rational actors and that the $100MM delta in "worth" vs the $200MM takeover consideration is justified by synergies. I went with the opposite assumption that it was a value destructive deal.

I would, however, like to clarify my answer. The $100MM dilution that I mentioned in my first post is dilution to existing equity holders. Enterprise value increases by $100MM (if you assume my value destructive deal) or $200MM as JD-to-IB notes (if you assume JD-to-IB's rational actors).

To your contention on #5, we are given the "actual market value of equity" PRE-TRANSACTION. The post-transaction value of financial instruments can be impacted by capital structure. If the business were over-levered to begin with, then an increase in debt mix would increase the WACC, therefore reducing the value of the firm.

Mar 30, 2012

For a much more knowledgeable and articulate explanation of the concept behind #5, I would direct those interested to the following discussion of optimal capital structure by Stern's Damodaran: http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds.... Slide 16 illustrates the concept of being able to optimize WACC (and consequently firm value) by adjusting debt mix. He goes on to apply this to a case study of Disney.

Mar 31, 2012

I apologize for the mis-guidance in my earlier post with the dividend impact to share price, I haven't dealt with equity values in EV in restructurings for quite some time given the under water nature of the debt for my deals.

However, as for Q5, I think the right answer should address the interest tax shield effect of the incremental debt and the accretive value that has to the enterprise value of the firm. Value of a levered firm = value unlevered firm + value of the interest tax shield - bankruptcy distress cost. I would think the interviwer, when explicitly adding taxes back to scenario 4 is trying to hint at the incremental EV the tax savings brings, which can be muted by the higher increase of financial distress given the higher amount of debt on the capital structure.

Mar 31, 2012

Anyone?

Mar 31, 2012

I know it is a bit late, but I run into the same question a couple of weeks ago at work, hope it is useful for anyone:

You have to think about it the other way around: You substract the equity investments (at market value, if possible) when you go from equity value (or market cap) to EV, so as you can obtain a "clean" multiple when it comes to benchmark vs. comparable peers. If you come from a DCF or a EV / EBITDA valuation, as you correctly said, you should add back the value of those investments to reach equity value.

If we are considering it in market value terms, rule of thumb is assuming that equity investors are taking in consideration the value of those investments when it comes to price the stock.

Hope it helps

Mar 31, 2012

minority interest is when you own 50% or more of a company. In such a scneario 100% of the owned company transfers his financial. Therefore EBITDA includes it but the share price does not include the whole price. To make it apples to apples, you add minoirty interest when going from equity to EV.

Likewise, with associates, it is 20-49.9% ownership and is reflective in the stock price, but not reflected in EBITDA, hence you have to take it away from the numerator so that both part of the fraction is using the same metrics. Therefore when you go from EV towards equity, you would most certainly add.

Mar 31, 2012

What is your goal (what number are you trying to get to?) I'm confused because you are talking about adding cash to enterprise value. If you want to go from enterprise value to equity value, then you would add cash and subtract debt. If you want to get to enterprise value, then you would add up the value of all financial claims (debt, equity, etc) and subtract cash and other excess assets.

When we are evaluating a business as an investment, we will do the latter [based on the price of the equity and the capital structure, what enterprise value are we paying, what price are we paying for the business operations]. Technically, you should only subtract *excess cash* and not total cash. A business requires some level of minimum cash to operate, and technically you should only subtract cash above that level. In practice, people typically subtract total cash because it's easier and it is not realistic to accurately estimate required cash levels for different businesses.

Mar 31, 2012

Think of the enterprise value as the theoretical "take over" price. If you were to buy the business and they had some cash, you could deduct the cash from the enterprise value thus making the "take over" price lower.

Mar 31, 2012

a business needs some cash to operate, therefore you would only subtract the excess cash. However, it is sometimes difficult to determine a company's optimal cash amount, so for simplicity purposes, all cash is deducted from EV

Jan 3, 2017
  1. No change in EV
  2. No change in EV
  3. EV up by $100M
  4. No change in EV
  5. EV up by $80M. Assuming perpetual debt, firm value increases by debt*tax rate = $200M * 40% = $80M
Jan 12, 2018
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Mar 3, 2019
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