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...
- ...the company issues US$200mm in new equity?
- ...the company issues US$200mm in new equity which US$100mm will be used to pay out as dividends to shareholders?
- ...the company issues US$200mm in new equity which will be used to invest in a business worth US$100mm?
- Please answer the above if US$200mm in new DEBT is raised (assuming TAX FREE world).
- What would happen to question 4 if taxes are now involved?
I answered as below:
- EV is still US$500mm because the US$200mm in new equity will offset US$200mm increase in cash
- 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)
- 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.
- Exactly the same answers as the issuance of new equity answers
- 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:
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).
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:
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:
Read More About Enterprise Value on WSO
- Enterprise Value and Minority Interest
- Market Cap vs. Firm Value vs. Enterprise Value
- Why subtract cash when we calculate Enterprise Value?
- Market Cap vs. Firm Value vs. Enterprise Value?
- What counts as "debt" in an enterprise value calculation?
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