Capitalization of Maintainable Earnings (LEVERED) Flashcards
Recapitalization Formula
If bringing the Debt-to-Equity Ratio down:
(debt - x ) / (equity + x) = Industry Standard Ratio
If bringing the Debt-to-Equity Ratio Up:
(debt + x) / (equity + x) = Industry Standard Ratio
Debt = $5,400
Equity (less redundant assets) = $800
D/E = 6.75
Industry Standard: 2.5
Adjustment:
(5400 - x) / (800 + x) = 2.5
x = 971
This means that an equity injection into the company of 971 would be required to pay down debt and bring the Company’s d/e ratio to the industry standard. On the balance sheet, debt would be reduced by 971, and equity would increase by 971. The Interest applied in an levered approach would be calculated based on this new debt level.
Steps in Levered Maintainable Capitalized Earnings Approach
1) Declare what method you are using and WHY.
2) Find EBIT (add back tax which will be reapplied once normalized earnings have been determined.) and Interest (will be added back following leverage adjustment).
3) Apply normalizing adjustments
- remove income or expenses from non-operating investments / redundant assets.
- adjust up or down wages to market rates for employees and management.
- remove one-time events (lawsuits, one-time contract revenue (and associated expenses), ect.
4) Determine the interest adjustment using the Recapitalization formula
- multiple the new debt position by cost of borrowing and add the adjusted interest rate back to earnings before they are taxed.
5) Determine maintainable earnings rate
- if consistent growth, the most recent year or weighted average (with weight on recent years) may be most appropriate. If fluctuating, a simple average or weight average may be most applicable.
6) reapply income taxes on maintainable earnings to get after-tax maintainable earnings.
7) Determine the ROE
- This is also a capitalization rate, but the levered version of WACC is called the Return on Equity.
- ROE can be found using the Build-Up approach or the CAPM approach.
- The multiples used in a Levered Approach are typically lower than in an unlevered approach, because the required rate of return in an unlevered approach is lower due to the inclusion of debt in the capital structure. (it looks wrong but thats what is says… i donno).
8) apply ROE Multiple to after-tax maintainable earnings to determine EQUITY VALUE (which is the levered version of Enterprise value).
9) Add redundant assets to Equity Value.
10) Add/deduct leverage adjustment.
- if debt was adjusted upwards, the adjustment amount is added to the Equity Value.
- if debt was adjusted downwards, the adjustment amount is reduced from the equity value.
11) this finds the en bloc FMV of equity.
