Technical Question - Buying back stock with debt
If a company is buying back stock with debt, how will that impact FV /EBITDA multiples?
(assume all else is equal)
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FV goes down by debt raised
EBITDA unchanged
Do the math
You should be good
TV will increase due to the tax shields from debt
EBITDA remains the same
Therefore the ratios will go up
EV rises because you have more debt but falls because that money is spent to lower equity value from the share buyback. EBITDA is pre-interest and taxes so there's no change at that level.
Downtown is correct. Stay tuned for more challenges.
Why does it go down?
EV = Equity + Debt If equity goes down and debt goes up, doesn't it remain unchanged?
Assuming you are saying you raise new debt to buyback stock, EV/EBITDA is unchanged minus any fees associated with the debt raise or buy-back which would lowered EV by the aformentioned fee amount. Tax shields do not come into play, What does EBITDA Stand For? Earnings Before Interest Tax Depreciation and Amortization.
Unchanged.
theoretically, it will remain unchanged. Like publicequity said, in the real world, ev/ebitda will slightly change because you will have fees associated with the debt raise / buyback, which would minimally decrease the amount of cash you receive to buyback shares. Because you can buyback less shares, your TEV will be higher.
Absent financial distress, if you are taking on debt to buy out shareholders it's likely you're decreasing wacc. EBITDA won't change since it's before interest...but the rate at which you discount FCFF will go down (hence TEV should go up)...isn't this the entire premise behind LBOs and adding value through debt (ie PE)?
Actually, more debt increases the levered beta of the company, which increases cost of equity.
The WACC decrease from lowered amount of equity is partially/fully offset by the increase in average cost of equity. I would say it is unclear whether WACC changes or not, so we should assume it doesn't for simplicity reasons.
Just my 2cents.
But you have proportionally less equity. It would be fully offset only in the case of financial distress (where taking on more debt is debilitating). Debt is cheaper than equity and you have more of it...hence lower wacc. No changes to FCFF so higher TEV...Really confused y this doesn't make sense to anyone else. I feel retarded.
Dude, just because debt is "cheaper" than equity, that doesn't lower the risk of the firm.
CAPM: COST OF EQUITY = rf+(levered beta) x market premium
and your levered beta = unlevered beta(1+D(1-tax rate)/E)
As debt (D) goes up and equity (E) goes down, your levered beta goes up, which increases cost of equity...
WACC = cost of equity x E/EV + cost of debt x (1-tax rate) x D/EV
Cost of equity goes up, and E goes down. In fact, cost of debt may also go up because your loading on more debt to buy back the equity. This lowers the firm's financial flexibility and hence increases WACC..
Why are you so sure WACC goes down?
The simple and basic answer for interview purposes is that it does not change anything.
Remember that FV= EV + Debt - Cash. So whether you use new debt or existing cash, the reduction in equity value is offset by the change in cash or debt.
However, for extra credit you can point out that the fundamental premise here is that the fundamentals of valuation DID NOT CHANGE. What does that mean? That FV is the basis that investors have used to value the company. But what if the company is fundamentally an EPS (and thus EV-driven) trader? An accretive (or dilutive) buyback would drive a change to equity value, a change that would cascade through to FV and impact the relative FV/EBITDA multiple.
GenghisKhan, can you elaborate on why the nature of the company (EPS driven vs non-EPS driven) matters? Keeping everything else constant, higher EPS would be favoured better than lower EPS companies.
If the equity value responds to this EPS change for 1 company, I don't see why it wouldn't for other companies, given that the transactions executed (the buy-back of equity) by those companies are the same.
The change of capital structure is not going to affect the EBITDA, as for the EV: 1) in an MM ideal world where there is not tax, it will not change because company value doesn't depend on capital structure in an MM ideal world 2) in an MM reality world EV will go up because Wacc will go down due to the tax shield on the debt 3) in an real reality world EV can go either up or down depending on where you are on the WACC curve since MM theory doesn't account for default risk on the debt so the WACC curve in MM reality world is downward sloping rather U shaped.
thx
There is no right or wrong answer concerning the WACC evolution. It can either go up or down depending on your leverage and cost of debt. And Shimness is right concerning the effect of leverage on cost of equity.
The OPs question was concerning EV / EBITDA ratio. Theoretically it stays unchanged if you are calculating your ratio based on market value (assuming all else is equal), but that has already been answered. If you were calculating your ratio based on fair value (DCF), it could change, as you have pointed out. But why would you do that?
Actually, if you're calculating the ratio based on market value, EV doesn't always have to stay the same either.
When you're buying back shares, this is acretive most of the time and creates upward pressure on stock price. This is somewhat similar to a reverse stock split. Equity value (market) can go up.
Yea, of course a share buyback would impact share price (either way depending on accretion of dilution of EPS), which would impact EV. GenghisKhan pointed this out earlier.
By "assuming all else is equal" I meant no change in share price, etc. I admit this probably wasn't really explicit.
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