Why do I pay for debt if I am acquiring a firm?

JoeySalads's picture
Rank: Monkey | banana points 59


I have always failed to understand the true meaning of enterprise value. What I do know is how to construct a DCF, find out all the free cash flows, terminal cash flow, discount them and end up with an "Enterprise value". I get confused when people tell me that this number inherits debt, and more confused when they say this is what I would pay for the company. I also get confused when they differentiate it to equity value.

Can someone please be a savior, consider me an amateur, and break it down for me in some simplified explanation?
Also what is the difference in getting an enterprise value using DCF and getting it this way: Enterprise Value = Market Cap + Debt - Cash?

Thank you!

Comments (3)

Dec 13, 2017

Think of it like a house, if I buy a house with a $100,000 down payment and $400,000 mortgage loan then the Enterprise Value is my $100,000 Equity Value + my $400,000 Net Debt, which equals $500,000 EV

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Dec 13, 2017

EV is considered the true / total value of acquiring a business. As a buyer, you want to take into account all parties that have a "stake" in the firm. Debt holders are owed money, and when a firm is acquired those debt holders will be paid out just like the equity holders. The acquiring firm's cost is both debt + equity of the acquired firm.

The reason that a DCF leads to Enterprise Value is that in a DCF, FCF that a firm generates is cash used to pay off equity AND debt holders (debt holders take interest out of FCF, and equity holders effectively receive the earnings that remain after all expenses) - it is "attributable" to both. The assumption here is that FCF is unlevered. Levered FCF is a company's FCF after all debt obligations have been paid (which is cash flow to equity holders) - if you used levered FCF in a DCF, you would result in equity value instead of EV.

Differentiating to equity value is just taking your 'implied enterprise value' calculated in the DCF and turning it into Equity value. You just do this using the normal EV formula EV = Equity + Debt + Minority Interest - Cash. Solve for Equity using balance sheet numbers: EV - Debt - Minority Interest + Cash = Equity value. Divide by shares outstanding for implied share price based on your model.

Hope that is helpful

    • 1
Dec 13, 2017

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