Basic Equity Value & Enterprise Value Quiz Flashcards
“Equity Value represents the ““sticker price of buying a company, whereas Enterprise Value represents…
1) The true, effective cost of acquiring a company, taking into account any cash you receive plus debt and debt-like items that must be repaid.
2) The cost to acquire the company, plus all of its subsidiaries.
3) The cost to acquire the company, net of cash.
4) The cost to acquire the company, after taking into account transaction fees and other expenses that arise in the course of a deal.”
“The true, effective cost of acquiring a company, taking into account any cash you receive plus debt and debt-like items that must be repaid.
A is correct because it is the basic definition of Enterprise Value. B is incorrect because subsidiaries have nothing to do with Enterprise Value. C is incorrect because it is not the complete answer - debt and debt-like items must also be factored in. D is incorrect because you never include transaction fees when calculating Enterprise Value - only existing items on the company’s Balance Sheet.”
“How do you calculate share dilution from options using the Treasury Stock Method?
1) Calculate how many new shares get created, and add those to the total share count.
2) Calculate how many new shares get created, and then subtract how many shares the company can repurchase with the proceeds it receives.
3) It depends on the type of options – you need additional information to answer the question.
4) You use the “If-Converted” method for options, not the Treasury Stock Method.”
“Calculate how many new shares get created, and then subtract how many shares the company can repurchase with the proceeds it receives.
Exactly what is stated in B - that describes the Treasury Stock Method. A is incorrect because you must also subtract the shares that the company can repurchase. C is incorrect because there’s only one ““option type”” here - call options - since put options do not affect dilution either way. D is incorrect because the ““If-Converted”” method is only used for Convertible Bonds.”
True or False: You use the same method to calculate dilution from stock options and convertible debt when calculating Equity Value.
“False.
The general idea behind calculating “in-the-money” stock options outstanding and convertible debt is similar in that both are additions to basic shares outstanding and will thus potentially have dilutive effect. But the methods are different. The method used for outstanding stock options is called the Treasury Stock Method (TSM), whereas the methodology used for convertible debt is called the If-Converted method. The difference is that in the TSM method, the cash proceeds received by the company are used to repurchase shares, whereas for the if-converted method, if the convertible debt’s conversion price is below the current stock price (i.e. “in-the-money”), then the entire equivalent amount of equity is factored in as dilutive, with no share repurchases”
“Why do we bother to calculate Diluted Shares Outstanding and Diluted Equity Value in the first place?
1) Because it’s a requirement – Basic Equity Value is completely wrong.
2) To more accurately assess the true cost of acquiring a company.
3) Because any investors that hold options, warrants, or convertibles, will definitely exercise them if they are able to, and that creates extra shares.
4) Because Enterprise Value itself is incorrect if you use Basic Equity Value instead.”
“To more accurately assess the true cost of acquiring a company.
CORRECT ANSWER
Explanation:
B is the best answer – because normally when a buyer acquires the company, the in-the-money options, warrants, and convertibles are cashed out, or must be replaced by the buyer, increasing the cost either way. Basic Equity Value is not “completely wrong” – it’s just less accurate – so A is incorrect. C is incorrect because investors won’t necessarily exercise options and other securities if they feel the stock price will continue to increase. D is incorrect because Enterprise Value is not “wrong,” just less accurate with Basic Equity Value.”
“When would you add an item to Equity Value when calculating Enterprise Value?
Answer Choices:
1) If you need to pay back the item immediately upon acquiring the company.
2) If it’s something that must be repaid in the future, but won’t come from the company’s ordinary cash flows from its business operations.
3) If you need the item for comparability purposes (i.e. if leaving it out would make valuation multiples inaccurate).
4) All of the above.”
"Your answer: All of the above. CORRECT ANSWER Explanation: These are the 3 most common conditions that must be true to add an item when calculating Enterprise Value. Debt is an example of such an item for A; Unfunded Pension Obligations is an example of an item for B; Noncontrolling Interests is an example for C."
”
Why do you subtract cash when calculating Enterprise Value?
Answer Choices:
1) Because it saves you money immediately after buying the company since you “get” the cash right away.
2) Because cash is not an official operating asset.
3) Because you can directly deduct cash from the official purchase price before buying the company.
4) None of the above.”
“Your answer:
Because it saves you money immediately after buying the company since you “get” the cash right away., Because cash is not an official operating asset., Because you can directly deduct cash from the official purchase price before buying the company.
CORRECT ANSWER
Explanation:
A is correct because cash saves you money after you acquire the company - you only receive it and add it to your own Balance Sheet once the acquisition is complete. B is also correct because items like cash, investments, and debt are related to the company’s investing and financing activities, and that’s part of the reason why they’re factored into Enterprise value. C is incorrect because you cannot deduct cash from the purchase price before buying the company - you still need to pay to acquire the shares outstanding from all investors.”
“Why do you add Noncontrolling Interests (AKA Minority Interests) when calculating Enterprise Value?
Answer Choices:
1) Because Noncontrolling Interests, just like Debt, must be paid off when a buyer acquires the company.
2) Because Noncontrolling Interests, similar to Unfunded Pension Obligations, must eventually be repaid but the funds will not come from the company’s ordinary business operations.
3) Because your revenue, operating income, EBITDA, and other metrics already include 100% of the financials from another company where you own between 50% and 100% - but Equity Value only reflects the value of the portion you own. To reflect 100% of the other company’s value, Noncontrolling Interests must be added in.
4) None of the above is the correct reason.”
“Your answer:
Because your revenue, operating income, EBITDA, and other metrics already include 100% of the financials from another company where you own between 50% and 100% - but Equity Value only reflects the value of the portion you own. To reflect 100% of the other company’s value, Noncontrolling Interests must be added in.
CORRECT ANSWER
Explanation:
Exactly what is stated in C - for purposes of comparability. A is incorrect because there’s no rule that states that the buyer must ““pay for”” the Noncontrolling Interests and acquire the rest of the company; B is incorrect for similar reasons, because Noncontrolling Interests don’t need to be ““repaid”” and are fundamentally different from Debt. D is incorrect because C states the correct reason.”
“Which of the following numbers could be negative?
Answer Choices:
1) Shareholders’ Equity.
2) Equity Value (Market Capitalization).
3) Enterprise Value.
4) None of the above could ever be negative.”
Equity Value can never be negative because a company’s share price must always be greater than or equal to $0, and its share count must always be positive. Shareholders’ Equity could easily turn negative if the company has been losing money, or if it issues very high dividends. Enterprise Value could also be negative if the company has an extremely large cash balance, minimal debt, and a low Equity Value.
“With which of the following metrics would you use Enterprise Value when calculating valuation multiples?
Answer Choices:
1) Net Income.
2) Unlevered Free Cash Flow (Free Cash Flow to Firm).
3) Levered Free Cash Flow (Free Cash Flow to Equity).
4) EBITDA.”
“Unlevered Free Cash Flow (Free Cash Flow to Firm)., EBITDA.
CORRECT ANSWER
Explanation:
Remember the litmus test: Does it include interest income and expense? If so, use Equity Value. Otherwise use Enterprise Value. Unlevered Free Cash Flow and EBITDA both exclude interest income and expense, so we use Enterprise Value. The others include interest income and expense, so we use Equity Value.”
“With which of the following metrics would you use Equity Value when calculating valuation multiples?
Answer Choices:
1) Net Income.
2) Unlevered Free Cash Flow (Free Cash Flow to Firm).
3) Levered Free Cash Flow (Free Cash Flow to Equity).
4) EBIT.”
“Net Income., Levered Free Cash Flow (Free Cash Flow to Equity).
CORRECT ANSWER
Explanation:
Remember the litmus test: Does it include interest income and expense? If so, use Equity Value. Otherwise use Enterprise Value. Net Income and Levered Free Cash Flow both include interest income and expense, so we use Equity Value. The others exclude interest income and expense, so we use Enterprise Value.”
“Assume ACME Co. has 10 million basic shares outstanding. Its current stock price is $40.00. It also has 800,000 stock options outstanding at an average exercise price of $20.00. Furthermore, ACME Co. has 150,000 Restricted Stock Units (RSU) outstanding. Finally, ACME Co. has $5 million of convertible debt outstanding, with a conversion price of $10 and a par value per bond of $1,000. What is ACME Co.’s diluted Equity Value?
Assume that in this same scenario, ACME Co. has $20 million in cash, $55 million in long-term debt, $30 million in Preferred Stock, and $15 million in Noncontrolling Interests. What is its Enterprise Value, assuming the same Equity Value you calculated above?
Now let’s assume that the company has $20 million in Net Operating Losses (NOLs), as well as $30 million in Unfunded Pension Obligations. Which of the following numbers is arguably correct for its Enterprise Value (again, using the same initial Enterprise Value and Equity Value you’ve calculated in the previous questions)?
What happens in this same scenario if ACME Co. also has $10 million in Investments in Equity Interests, $20 million in Capital Leases, and $30 million in highly liquid, short-term investments?”
“First, let’s tackle the options outstanding: since they are in-the-money(exercise price is lower than the share price), we assume that they get exercised and that 800,000 new shares get created. The company receives 800,000 * $20.00, or $16 million, in proceeds. Its current share price is $40.00 so it can repurchase 400,000 shares with these proceeds ($16 million total proceeds / $40 per share). Overall, there are 400,000 additional shares outstanding now from the total options outstanding (800,000 new shares – 400,000 repurchased). The 150,000 RSUs will get added as if they were common shares, so now there’s a total of 550,000 additional shares outstanding. Next, we need to divide the value of the convertible bonds – $5 million – by the par value per bond – $1,000 – to figure out how many individual bonds we get (since the convertible debt is in-the-money): $5 million / $1,000 = 5,000 convertible bonds. Next, we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: $1,000 / $10 = 100 shares per bond. So we have 500,000 new shares (100 additional shares per bond* 5,000 bonds total) created just by the convertibles, giving us a grand total of 11,050,000 diluted shares outstanding. Once again note that we do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us. The final step to determine Equity Value is to multiply the total diluted share count of 11,050,000 by the current market price per share of ACME Co. of $40, which results in a final total Equity Value of $442 million.
The correct Equity Value here is $442 million. You subtract the cash of $20 million, add the debt of $55 million, add the $30 million of Preferred Stock, and add the $15 million of Noncontrolling Interests, so the answer is $522 million.
As mentioned in the interview guide, there is no explicit rule that states that you must subtract NOLs and that you must add Unfunded Pension Obligations when calculating Enterprise Value. These advanced items are very much in the “grey zone” and treatment of them is not as universal as the treatment for normal cash and debt is. So you might see people and banks that include some of these, all of these, or none of these when calculating Enterprise Value. NOLs, in particular, are often left out entirely because the buyer can usually only utilize only a small fraction in an M&A deal.
Both Investments in Equity Interests and highly liquid Short-Term Investments are considered cash-like items, so you subtract them when calculating Enterprise Value; Investments in Equity Interests are also partially about comparability because revenue and expenses from them do not show up in metrics like revenue, EBIT, and EBITDA. D is incorrect because the treatment has nothing to do with the specific percentage ownership – as long as it’s below 50% and the Investments therefore count as “Equity Interests,” you subtract them.”
