Levered Recap vs Just Issuing Debt - EB Interview Question
Hey monkeys, got asked these at an EB interview and would be great if anyone with more experience could chime in.
How would taking on more debt to repurchase shares affect the share price? (levered recap). How would issuing more debt affect the share price?
For levered recap, my thought process is that under a frictionless world (not violating any MM assumptions on tax, bankruptcy), then:
More debt, less equity value → EV stays constant.
Less equity value = lower market cap. Greater risk because the claim is even more residual.
However, also lower # of shares → so price is constant (assuming debt is issued at fair value).
However, for taking on more debt in general, I know that doesn't affect equity value. How then does taking on more debt affect share price? Wouldn't the levered recap thought process not make sense because there would still be the same equity value/market cap? Thanks.
Def. a tough Q. Would you mind sharing which EB this was from. I'll give it a shot. I think generally, assuming MM assumptions and/or ignoring change in market sentiment, neither raising debt or doing a leveraged recap should impact the share price.
But there are practical considerations. For example, if the stock is undervalued, a leveraged share repo could lead to a increase in share price b/c EPS increases and there's more "demand" for the stock. With debt generally, it shouldn't impact equity value theoretically, but increased debt drives WACC up after a certain point, and would lead to both a smaller implied EV and equity value. If that happens, share price would decrease?
I could be totally wrong though.
For the first part of your response, I do agree that share price won't change in the event of a leveraged recap (not sure about issuing debt). But isn't the reason why there is no change in share price because Equity Value/market cap decreases by the same amount that the # of shares outstanding does? Because otherwise, if equity value is assumed to stay the same, the # of shares outstanding would decrease (b/c buyback), so share price should increase.
But then I don't understand how equity value stays the same in the event of just issuing stock.
Agree with the practical considerations you noted!
Theoretically speaking, there is no change in equity value/share. But back to your question, if a reciprocal of PER at where repurchase was made is higher than after-tax cost of debt, EPS will be increased and share price will go up, and vice versa.
But it would only make sense under the EMH, which I think complete BS. In real world, what really drives the price related to the repurchase program has to do with "How much discount that repurchase enjoyed compared to intrinsic value". Just my 0.02. Correct me if i'm wrong
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