Tough Question from Evercore

notmeno's picture
Rank: Monkey | banana points 31

Boys,

If a firm takes a lot of debt to buy back stock, will market cap decrease?

I know diluted shares outstanding will decrease, so prices would increase?

How do you know that mrkCap will decrease for sure?

Comments (35)

Aug 11, 2017

market cap will depend on what happens to share price, but unless it immediately adjusts perfectly, market cap will probably decrease? Thats my guess.

Aug 11, 2017

why would debt effect the market cap? it will certainly effect enterprise value. i agree with the above poster.

Aug 11, 2017

I think you're confused. Debt has no almost impact on enterprise value, unless we're talking about not using any debt (inefficient capital structure relying too much on higher cost of capital using all equity) or levering up a company to the point of potential bankruptcy.

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Aug 11, 2017

I think you're approaching this too qualitatively. equity value will probably drop as EV increases. Usually borrowing debt and buying equity with it will increase the value of the whole company equivalent to the proceeds from the tax shield (with no other factors affecting it). Let's assume the company starts with $100 equity, borrows $50 debt, and has 30% taxes. After repurchasing equity with the debt, the new value will be $100 + $50*30% = $115. Subtract the $50 in debt to get the new equity value of $65.

Let me know if this is wrong. I tried to approach this in a purely quantitative way.

Aug 11, 2017

Isn't debt more risky than equity? if so the company's capital structure becomes more levered. investors may react poorly to this especially if the company is in a cyclical industry. so as a result, market cap would decrease, assuming a perfect correlation between the stock's price and quantity (i.e. market stays the same at 100 shares vs 50 shares as the price would just increase/decrease)

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Aug 11, 2017

A buyback is a vote of confidence from internal management. It could be them putting their money were their mouth is so it could also increase regardless of the debt. It depends.

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Aug 11, 2017

If you assume that share price doesn't change, then the market cap certainly decreases. Would share prices increase - to the point where the market cap after is larger the pre-buyback market cap? Firstly, depends on how many shares were bought back. For example, if 50% of shares were bought back, then stock price would have to more than 100% (which you can guess is very unlikely within a short span of time) for the market cap to be greater than pre-buyback market cap.

Decreasing the shares outstanding through a buyback will generally increase shareholder value (short and long term) because it increases the EPS (earnings per share) which means each share of the company after the buy back is entitled to a greater amount of earnings / cash flow. Hence, share price will increase.

That's a good answer. Though, there is no concrete answer whether a buy back will increase/decrease market cap.

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Aug 11, 2017

The answer is it depends. a big reason to use enterprise value instead of equity value is because it is less easy to toy with like this.

The share price may go up (earnings per share increases, even after the increase in interest expense), but the share count goes down. The actual impact will depend on how the market views the signal sent by management via the buyback.

The impact of levering up the firm depends on a host of factors (tax rate, existing leverage, interest rates).

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Best Response
Aug 11, 2017

It's a recapitalization, so generally speaking equity value should decrease as the enterprise value shifts its mix from equity to debt. Take a look at this:
https://chrismercer.net/leveraged-dividend-recapit...

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Aug 11, 2017
Charizard:

It's a recapitalization, so generally speaking equity value should decrease as the enterprise value shifts its mix from equity to debt. Take a look at this:
https://chrismercer.net/leveraged-dividend-recapit...

SB'd

Aug 12, 2017
Charizard:

It's a recapitalization, so generally speaking equity value should decrease as the enterprise value shifts its mix from equity to debt. Take a look at this:
https://chrismercer.net/leveraged-dividend-recapit...

This assumes a frictionless market.

  1. So in a frictionless market (no bankruptcy costs/taxes), you're right. Leveraged share repurchase would have no impact on EV but would decrease equity value (additional risk shifted onto equity holders - this is why there's no change in EV).
  2. In a market with taxes, leveraged share repurchase would increase EV via interest tax shield but it's unclear if equity value would change. Equity owners earn the benefit of the tax shield (tax shield does not benefit debt holders. Value is accrued to equity holders as it increases FCFE) but it's unclear if the gain from the tax shield offsets the increased risk placed onto equity holders from additional debt.
  3. In a world with bankruptcy costs, the calculation becomes even less clear. A leveraged share repurchase may actually reduce EV and equity value.

Wordy response but hope it helps.

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Aug 11, 2017

How do you figure a leveraged buyout would increase EV? Isn't the whole point of EV a valuation of a company independent of capital structure (besides potentially a lower WACC)?

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Aug 11, 2017

The obvious answer is what people above have already said (management is confident etc. so market cap rises).

But, this question is specifically asking what (theoretically) happens when you use debt to buy back shares. Three considerations here: i) theoretically, how does equity value change in a buy back (regardless of debt) - it doesn't. S/O goes down, EPS goes up, P/E stays constant, so market cap stays the same - same pie, just fewer slices, ii) how does debt impact EPS: interest - this essentially boils down to an accretion / dilution analysis where lower interest drives down net income but lower S/O drives up EPS (so you have to understand which one has a greater impact, and (assuming constant P/E) the greater force will ultimately drive market cap), and iii) how does WACC change in this specific scenario - depends where you are in the WACC curve but odds are WACC decreases due to the greater percentage of debt that makes up your capital structure - therefore, lower WACC = greater EV = greater market cap (even after adjusting for additional debt).

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Aug 11, 2017

Thanks for this, makes a lot of sense.

But why does lower WACC = greater EV? The company is less "risky" so investors will pay a higher price for the share?

Aug 11, 2017

Implied EV*. Lower discount rate will increase EV

Aug 12, 2017
ysob2:

i) theoretically, how does equity value change in a buy back (regardless of debt) - it doesn't. S/O goes down, EPS goes up, P/E stays constant, so market cap stays the same - same pie, just fewer slices,

I don't know what you mean by S/O, but higher leverage on equity would indeed impact P/E.

ysob2:

and iii) how does WACC change in this specific scenario - depends where you are in the WACC curve but odds are WACC decreases due to the greater percentage of debt that makes up your capital structure

This statement blatantly violates Modigliani Miller. It's true that WACC would decrease in a world with taxes, but not for the reason you highlighted.

Aug 11, 2017

What do you mean by "This statement blatantly violates Modigliani Miller. It's true that WACC would decrease in a world with taxes, but not for the reason you highlighted."?

WACC does decrease of higher % of debt in the capital structure...?

Aug 11, 2017

Your equity value will decrease, but your value per share will increase.

Think of it like this. The business is worth 10x EBITDA. Currently, the business is 4x levered. The recap increases the debt load to 6x ebitda. This does not change the EV. Instead, it increases LTV, so equity value is lower. However, since you're buying up shares, EPS increases, and the value of shares increase.

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Aug 11, 2017

I don't think you can have it both ways - if you're assuming constant EV, then share price can't increase at all otherwise equity value would be decreasing by slightly less than cash which would mean EV goes up.

Aug 11, 2017

Nope. You're forgetting that this transaction decreases shares outstanding. So EV stays the same, equity value decreases, shares outstanding decreases, equity value per share increases.

Again, I'm not considering the possibility of a lower WACC which could increase EV.

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Aug 11, 2017

The fact that there is such a long thread on just one question from Evercore is a testament to how hard Evercore's interview process is.

Aug 12, 2017

Shit man this is what I was thinking

Aug 12, 2017

More of a reflection of how clueless WSO is.

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Aug 12, 2017

uh so wat is the answer

Aug 14, 2017

As in most ib interview questions, the answer is: it depends

What does it depend on? Size of the buyback and share price post-buyback.
Change in market cap will be [zero] if [new share price/old share price - 1] equals [shares purchased/post-buyback shares outstanding]. If share price is higher, market cap will increase; converse is true.

There are a number of factors that will then affect whether the share price goes up or down, as the post-buyback share amount is constant. Things to consider include:

  • WACC: will the increased debt load bring the company above its optimal capital structure? a lower WACC will result in a higher share price
  • Interest Coverage: will the debt load raise doubts about the company's ability to pay off existing debt? this will lower the share price

etc.

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Aug 11, 2017

Just like everyone else, you're completely ignoring the effect of taxes. Increasing debt creates a tax shield for the company (assuming there's no risk of bankruptcy - bankruptcy costs - factored in)

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Feb 13, 2019

Market cap goes down. Plan and simple. The change in EV is not certain.

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