Best Response

It's not necessarily used to pay down debt, extra cash simply decreases your cash purchase price. You pay \$100 in cash for equity, which consisted of \$20 in cash. So with your \$100 you are buying \$80 of company and \$20 of cash. You pay 100, but receive 20 the same day, so your net cash outflow is 80.

EV is theoretically the npv of future free cash flows to the firm - owned by both debt and equity holders. Cash that has already been earned doesn't matter, the firm's value is dependent solely on the cash it will generate in the future. In this case, the net present value of future free cash flows to the firm is 80 (firm value or EV).

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A firm has 100 in equity, 40 in debt and 20 in cash.

To acquire it, you need to pay 100 to the equity holders and 40 to the debt holders (total 140), and you will receive 100 of equity and 20 of cash (total 120). Since you paid 140 and received 20 in cash you effectively paid 120 (i.e., 140 - 20 = Equity + Debt - Cash)

lets take this example
*Company A: MVequity =100 ; Cash =20
*Company B: MVequity = 100

To acquire B, you pay 100, and you receive equity worth of 100
To acquire A, you pay 100, you receive equity worth of 100 and cash amount of 20, so you effectively paid \$80

So what this is saying is that is that if everything equal, if a company has more cash, I should pay less.
Which contradicts some common sense, that i company with MVequity =100 and Cash of 20 should ask more for more money than a company with MVequity of 100.

so there is something definitely wrong in the analysis or I am missing a different aspect of the analysis

.............

Lets look at it from the sellers point of view: who got richer
If he had MVequity =100 and Cash= 20 === > You would pay him 80 in an acquisition (EV=MVequity - Cash = 80)
If he had MVequity = 100 and no cash ===> you would pay him 100.

Who is richer now? the company that did not have cash which contradicts common sense. Actually, the company that had cash should be richer

Lets also think of it from another perspective:
If he had MVequity =100 and Cash= 20 ==> I would pay 80 and receive MVequity =100,
Suppose, then i sell my MVequity = 100 to another party

Net Cashflows: -80 +100 = 20! so there was an arbitrage

I am not trying to prove that EV is not 80, all I am saying is that there should another justification why EV=80

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PV Future Cash Flow Stream = EV..for this example = 80 + Company has 0 debt 20 cash -> Shareholders own an \$80 cash flow stream and \$20 of cash, Equity = 100

And that arbitrage scenario is not how it works. To effectively pay 80 for 100 in equity with 20 of cash, you would either be paying a dividend or not need to fund a cash balance. If you pay a dividend to yourself, EqV is immediately worth 80. If you leave the cash in and sell the company at 100 EqV, you don't get the cash, so it's as if you paid 100 to begin with.

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I see where is the problem... You are confusing one really important thing here: EV is NOT the price you pay for a company. At most, you could see it as the 'real price' you pay for it (i.e., if I pay 120 and I receive 20 cash, the 'real price', EV, I paid was 100). Go back to my previous example and see that while the price I paid for the company was 140, the EV of the company was 120.

Remember, price is what you pay, value is what you get.

so lets say
A: EV = 100; MV equity =10; Debt =90
B: EV = 100; MV equity = 80; debt = 20
The "price" you are paying is 100 for both A and B;
The value that you are getting is 10 for A and B for 80

What would be the arguments in support of buying company A ?

No, the value you are getting is 100 for both. That 90 debt will be used in the future to finance an expansion, new machinery, or whatever, so you will get future CF from that debt as well.

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The two companies in this example do not have the same value. Company A's EV is 80, B's is 100. The shareholders of company A also have claim to \$20 in cash, so their equity value is company + cash (80+20).

Maybe the interplay between EV and equity value is confusing you. When you acquire a company's equity, you are acquiring ownership of a future stream of cash flows (Enterprise Value). The actual firm value to you, the equity holder, is contingent on two primary areas (negating preferred & MI): what portion of the cash flows are owned by another party (debt holders) and how much cash that you can take from the business on day 1. Let's look at a couple of scenarios:

Company with 80 EV and 20 Cash...The cumulative present value of future cash flows is worth 80, and you can pay yourself a cash dividend of 20 today. The value of equity in this company is 100

Company with 80 EV, 30 Debt, 20 Cash...Cash flow stream is still worth 80. Now, 30 of those cash flows are owned by debt holders (which take precedence over you). At the same time, you own 20 in cash, which you can use to buyback some ownership of those cash flows (paydown debt) or pay yourself a dividend - doesn't matter. Regardless, the value of equity in this company is 70 (80 - 30 + 20).

In both of these scenarios, the company is worth \$80 (EV). equity value changes based simply on how cash flows through to shareholders. This is why, all else equal, if two companies have the same equity value, the one with less cash has a higher enterprise value - the company is worth more.

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Thank you so much for the thoughtful response!
The concept is sinking in.

johnlayan:

Thank you so much for the thoughtful response!The concept is sinking in.

I would hope it is after you've started 10 threads about it

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Presentvalue:

lets take this example*Company A: MVequity =100 ; Cash =20*Company B: MVequity = 100

To acquire B, you pay 100, and you receive equity worth of 100To acquire A, you pay 100, you receive equity worth of 100 and cash amount of 20, so you effectively paid \$80

So what this is saying is that is that if everything equal, if a company has more cash, I should pay less.Which contradicts some common sense, that i company with MVequity =100 and Cash of 20 should ask more for more money than a company with MVequity of 100.

so there is something definitely wrong in the analysis or I am missing a different aspect of the analysis

For company A, the value of discounted future cash flow is 80, while the company has 20 cash. When you pay 100 for this company, you get only 80 equity value generated by future cash flows, meaning that the expected cash flow of this company is somewhat lower than company B, therefore, your net outflow is essentially only 80.

For company B, the value of the discounted future cash flow is 100. Market thinks the company is making more in the future, therefore you pay more out of pocket.

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.

Another interesting spin on this (that I don't believe anyone mentioned) is that cash is implicitly factored into your EV; so you don't want to double count cash in your EV computation. If you think about setting up a DCF in order to calculate an implied intrinsic share price, you are factoring in Cash into your equity value by using the FCF metric to compute it. I hope that adds some insight to your newly acquired perspective!

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Not sure if I follow. Well yes cash is included in equity value but is not in FCF.

with FCF you calculate EV which captures operating assets. So cash is not included there. Then you adjust it and come to equity value. But the DCF itself does not incorporate a non operating asset such as cash.
Are we saying the same thing?

FCF by definition is post-reconciliation of Net Income back to (Free) Cash. You remove Cash balance from EV so you don't double count it, because Cash has already been factored in implicitly into the EV through use of FCF to get there. It's just another way to think about it.

We're talking about cash already on the balance sheet. EV is cash the company will generate in the future, yes, but cash on the balance sheet has already been earned. That reason is not why you take cash out.

Pardon me if I am missing something in your example but...the usual simplified formula for EV is EV=MVEquity - Net debt. Assuming you have no debt, net debt is negative by the cash amount. So EV is 100 - (-20), which is 120 not 80?

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EV = mv equity + net debt

Net Debt = Gross debt - cash
EV=MVequity + Gross Debt - Cash
EV=100 + 0 - 20 =80

According to your posts you did SA at a BB........come on dude

Stupid mistakes happen my dear timmy, don't be the douche on his white horse that never gets invited out by other analysts. Though according to your posts you may fancy the idea of changing your name to "Incoming annoying guy at Bank X"

Real life equivalent to this discourse: everyone else is trying to explain EV to this kid, and after 20 minutes you interject with "wait you guys aren't calculating the formula correctly." ... Guess who's not getting invited out

Coming from someone who hasn't actually worked in the industry and thinks he should update his linkedin to "invited for interview" hahahaha. I'll leave it at that buddy

Sarcasm is difficult to recognize for some people, so I'll let it slide this time.

HOW THE FUCK IS THIS THREAD STILL HAPPENING

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Are you sure finance is for you? This is some pretty basic stuff here.

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