I just finished level 1 and will be interviewing for ibanking next week. I dont know if they cover this in the cfa, but does anyone know why you must add debt to market capitalization when calculating enterprise value? if a company has a market cap of $100M, and $20M of debt, ignoring cash, why would the enterprise value be $120M? why wouldnt you subtract the debt? wouldnt you naturally subtract debt from equity to calculate net worth?
You’d subtract debt from assets to get to net worth… Here’s the classic example of why you add them: imagine there is a house worth $100. Let’s say you put $20 down and take out a mortgage for the other $80. What’s the value of the house? EV is an extension of the Modigliani and Miller theorems saying that capital structure is irrelevant. Also, when explaining enterprise value, don’t forget to add back cash. Equity value + MV of Debt - cash Why do you add back cash? 1) Because the PV of dollar is worth a dollar, if it’s excess cash it’s not an operating asset 2) Because you could use the dollar to pay down some of the debt 3) Because the other side to most enterprise value multiples (generally EBITDA or FCFF) don’t include the interest income earned on cash/cash equivalent balances and thus you’d be comparing apples to oranges.
Another way to think of it is, when a buyer buys pays $100K for the company, he inherits the debt of $20K, which must be paid as well, totaling $120K. Therefore, debt is added to arrive at EV.
i don’t understand how someone can even get past L1 without understanding what firm value is. sorry, mate, but you do not deserve that ibanking interview. its nice of the other guys to try to help you, but you need a big kick in the butt, so you pay attention to your corporate finance and learn the elemental basics at least before you get billed to an unsuspecting client for your mediocrity.
Think of enterprise value as the theoretical takeout price for a company. If you were to acquire a company at its theoretical value, you’d not only have to pay for its market capitalization (shares times price per share), but also assume its existing debt. However, you’d also be able to pocket any cash and short-term investments (or cash equivalents) it had on the books. Thus, enterprise value = market cap + debt (& minority interest and preferred shares) - cash & cash equivalents. Obviously, that is the theoretical definition. As an aside, in practice, companies are taken out at a premium to its enterprise value at the time of the deal announcement, i.e. the implied EV will be greater than the current EV. Why? Because people don’t want to sell the company unless it’s at a premium to what it’s already worth. I hope this helps - just another way to think about enterprise value.
giatch - good luck in your interview! i hope you have good news to report to us!
is total enterprise value the same as liquidation value? liquidation value The estimated amount of money that an asset or company could quickly be sold for, such as if it were to go out of business. If the liquidation value per share for a company is less than the current share price, then it usually means that the company should go out of business (or that the market is misvaluing the stock), although this is uncommon.
pacmandefense Wrote: ------------------------------------------------------- > is total enterprise value the same as liquidation > value? > > liquidation value > The estimated amount of money that an asset or > company could quickly be sold for, such as if it > were to go out of business. If the liquidation > value per share for a company is less than the > current share price, then it usually means that > the company should go out of business (or that the > market is misvaluing the stock), although this is > uncommon. Enterprise value is not fundamentally related to liquidation value. Liquidation is simply the current market value of the company’s assets (fixed and intangible) minus the comapny’s debts (bank and trade). For trade receivables, you would typically asses what amount can be collected in a short period of time (eg. 30 days) and use that as your value. Enterprise value is a concept usually applied in a takeover context of healthy firms. Therefore, I would say the major difference is that LV is applied to situations where you cannot assume the company is a going concern. Having said that, I disagree with the comment above with regard to liquidation value vs. share price. You would typically value a healthy company above the current net market value of its assets, because the company’s operations - customers, management, supplier relationships, etc. - all add value. Therefore, I would argue the other way around - if the liquidation value exceeds market value, the company should go out of business, because you could make a profit by buying out the company and then liquidating it.
think of it terms of a house. The total value of the house is the owners equity plus the mortgage (at closing of course). So if someone bought a house for 50,000 and borrowed 25,000…they would have equity worth 25,000 and debt worth 25,000 and the house would have a total value of 50,000. it is a very simple analogy which helps in terms of imagining an “enterprise”
Billy Collins Jr. Wrote: ------------------------------------------------------- > pacmandefense Wrote: > -------------------------------------------------- > ----- > > is total enterprise value the same as > liquidation > > value? > > > > liquidation value > > The estimated amount of money that an asset or > > company could quickly be sold for, such as if > it > > were to go out of business. If the liquidation > > value per share for a company is less than the > > current share price, then it usually means that > > the company should go out of business (or that > the > > market is misvaluing the stock), although this > is > > uncommon. > > Enterprise value is not fundamentally related to > liquidation value. Liquidation is simply the > current market value of the company’s assets > (fixed and intangible) minus the comapny’s debts > (bank and trade). For trade receivables, you would > typically asses what amount can be collected in a > short period of time (eg. 30 days) and use that as > your value. Enterprise value is a concept usually > applied in a takeover context of healthy firms. > Therefore, I would say the major difference is > that LV is applied to situations where you cannot > assume the company is a going concern. > > Having said that, I disagree with the comment > above with regard to liquidation value vs. share > price. You would typically value a healthy company > above the current net market value of its assets, > because the company’s operations - customers, > management, supplier relationships, etc. - all add > value. Therefore, I would argue the other way > around - if the liquidation value exceeds market > value, the company should go out of business, > because you could make a profit by buying out the > company and then liquidating it. thanks
“but does anyone know why you must add debt to market capitalization when calculating enterprise value” This is it THIS way. Enterprise is the hole enchalada see. The debt part stems from the fact that when you own the hole enterprise you can do basically whatever you want with the compan like liquidate assets. Lets say that you financed those assets with debt issuance. Adding the debt figure to the stock takes care of that outstanding liability. Willy