Equity and Enterprise Value

Question 1

Which of the following statements correctly states the MEANING of Equity Value and Enterprise Value?

Conceptual Questions

Answer 1

Equity Value represents the value of the company’s Net Assets, but ONLY to common shareholders, while Enterprise Value represents the value of ONLY its Net Operating Assets, but to ALL investors.
Explanation: The second answer choice states the real definitions of Equity Value and Enterprise Value, per the guides. The other statements are not “wrong,” necessarily, but they don’t explain the REAL MEANING of these concepts – they just give the calculations or the partial intuition.

Question 2

What is the MOST likely reason why a company’s Implied Enterprise Value is $5 billion, even though its Current Enterprise Value is only $4 billion?

Conceptual Questions

Answer 2

Because you’re assuming a higher Cash Flow Growth Rate than the market is.
Explanation: The last answer choice is correct. Since Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate, one of those numbers must be different if the Current and Implied Enterprise Values differ. The Cash Flow Growth Rate is the one that’s most likely to differ because a company’s Cash Flow
is based on historical information, and the Discount Rate is based on comparable companies (the same goes for the assumed future capital structure).

Question 3

Which of the following statements BEST explains why you subtract Cash when moving
from Equity Value to Enterprise Value?

Conceptual Questions

Answer 3

Because Excess Cash is a Non-Operating Asset, and as a simplification, you count the entire Cash balance as Non-Operating and subtract it.
Explanation: The second answer choice is correct; since Enterprise Value excludes Non-Operating Assets, but Equity Value includes all Assets, you must subtract Non-Operating Assets such as Excess Cash when moving from Equity Value to Enterprise Value. The first answer is not quite correct because technically, only Excess Cash (i.e., the amount above the minimum level the company needs for its operations) is a Non-Operating Asset. The third answer may be true, depending on the deal, but it is not the real conceptual reason why you subtract Cash. And the last answer is false because Cash cannot necessarily be used to repay Debt; many forms of Debt prohibit early repayment.

Question 4

True or False: Equity Value cannot be negative, but Enterprise Value can be negative.

Conceptual Questions

Answer 4

Need more information to determine this.
Explanation: The third answer choice is correct because you must distinguish between CURRENT and IMPLIED Equity Value and Enterprise Value. Current Equity Value cannot be negative because Current Equity Value = Share Price * Shares Outstanding, and both of those must be positive. Current Enterprise Value could easily be negative if a company’s Equity Value is low, and its Cash exceeds its Debt. However, IMPLIEDEquity Value and IMPLIED Enterprise Value could both be negative because they are based on your valuation assumptions for the company. The answer would be “True” if we wrote “Current” Equity Value and Enterprise Value and “False” if we wrote “Implied” Equity Value and Enterprise Value.

Question 5

If a company issues $100 of Common Stock to increase its Cash balance, why does its Current Equity Value increase, but its Current Enterprise Value stay the same?

Conceptual Questions

Answer 5

All of the above.
Explanation: Everything above is true; Current Enterprise Value changes only if the company’s core business operations, or Net Operating Assets, change. But Cash, or Excess Cash, as well as Stock, both relate to financing rather than operations. For Equity Value to change, Common Shareholders’ Equity must change; if CSE does not change, Equity Value cannot change. For Enterprise Value to change, Net Operating Assets must change, which explains the second answer choice.

Question 6

Which of the following changes would DEFINITELY affect both a company’s Enterprise Value AND its Equity Value?

Conceptual Questions

Answer 6

The company issues Equity to acquire additional PP&E.
Explanation: Only the second answer choice would affect both a company’s Enterprise Value and its Equity Value. For Equity Value to change, Common Shareholders’ Equity must change. In the last answer choice, CSE does not change because it’s a simple Debt issuance, which rules out that choice. In the other three choices, CSE does change, so Equity Value changes. But in the first choice, the Assets might be Non-Operating, in which case Enterprise Value will not change. And in the third choice, Net Operating Assets does not change. That leaves the second answer as the correct one: PP&E is an Operating Asset, and no Operating Liabilities change, so NOA increases, and so does TEV.

Question 7

If a company has Preferred Stock with a fixed coupon, which of the following metrics are VALID to pair with its Equity Value for use in valuation multiples?

Conceptual Questions

Answer 7

b. Net Income to Common.
c. Levered FCF.
Explanation: Equity Value in the numerator of valuation multiples does NOT include Preferred Stock. It just reflects the market value of Common Shareholders’ Equity. Therefore, any denominator used with Equity Value must DEDUCT Preferred Dividends – the Income Statement expense associated with Preferred Stock – to be a valid multiple. Net Income deducts Net Interest Expense, but not Preferred Dividends, so it is invalid. EBITDA and NOPAT deduct neither one, so they are invalid. Only Net Income to Common and Levered FCF deduct both these items, so they are the only valid metrics here.

Question 8

Why does Enterprise Value NOT necessarily represent the takeover price of a company?

Conceptual Questions

Answer 8

a. Because an acquirer may not be able to “take” the seller’s entire Cash balance.
b. Because an acquirer may or may not refinance the seller’s Debt.
c. Because there are almost always extra fees associated with an acquisition.
d. Because the deal might include earn-outs or contingency payments not reflected in Enterprise Value.
Explanation: Everything above is true: Enterprise Value is often close to the “takeover price” of a company, but it’s rarely equal to the exact price because of the treatment of Cash and Debt and transaction-related fees. If the deal is structured to include additional payments over time, such as earn-outs, then Enterprise Value also won’t reflect the full price.

Question 9

Company A has an Enterprise Value of $500 million, and Company B has an Enterprise Value of $900 million. Why can you NOT conclude that Company B is “more expensive”?

Conceptual Questions

Answer 9

Because you don’t know how the revenue, EBITDA, and other metrics of Companies A and B compare.
Explanation: The third answer choice is correct. You can’t just use
Enterprise Value or Equity Value to compare different companies
because they might be different sizes; it would be like comparing the
price of a mansion to a small apartment. You need to look at companies’
values on a “per-unit basis” using valuation multiples instead. Whether
these metrics are Current or Implied is less relevant than the fact that
they’re not a per-unit basis. Equity Value vs. Enterprise Value also
matters less because of the same issue.

Question 10

When you use EBITDAR in the denominator of a valuation multiple, which of the
following is VALID to use in the numerator?

Conceptual Questions

Answer 10

Enterprise Value Including On-Balance Sheet Operating Leases.
Explanation: The second answer choice is correct. If the denominator of a valuation multiple EXCLUDES or ADDS BACK an Income Statement expense, then the numerator must include the corresponding Balance Sheet line item. So, with EBITDAR, the numerator must add the company’s on-Balance Sheet Operating Leases to be valid. Equity Valuenever pairs with EBITDAR because Equity Value never pairs with EBITDA, as they represent different investor groups, which makes the third and fourth answers wrong. The fifth answer is wrong because the only difference under IFRS is that EBITDAR = EBITDA, and you normally add Operating Leases to TEV by default. But the principle is the same: if the numerator includes a Balance Sheet line item, the denominator must exclude or add back the IS expense associated with it.

Question 11

Which of the following is a VALID interpretation of a valuation multiple, such as 11x TEV / EBITDA?

Conceptual Questions

Answer 11

a. This type of valuation multiple is “shorthand” – an abbreviation – for a company’s Cash Flow, Cash Flow Growth Rate, and Discount Rate.
b. Relative to other companies in the same industry with similar financial profiles, this multiple tells you if the company might be overvalued or undervalued.
c. The reciprocal – 1/11 or 9.1% – tells you how much EBITDA you’ll earn for each $1.00 invested proportionately in the company’s entire capital structure.
Explanation: Everything above is true. Multiples represent shorthand for a company’s Cash Flow, Cash Flow Growth Rate, and Discount Rate (when the Cash Flow and Discount Rate are held constant, a higher Cash Flow Growth Rate produces a higher multiple), and they also tell you ifthe company might be mispriced compared with peer companies. The reciprocal of a multiple also gives you “the yield” – how much you’ll earn for each $1.00 invested in a company (either in its Equity or the entire capital structure).

Question 12

Why is it important to pick companies that are similar in size, geography, and industry when creating a set of comparable public companies in a valuation?

Conceptual Questions

Answer 12

Because each company’s Discount Rate should be similar so that the differences in multiples correspond primarily to different growth expectations.
Explanation: The first answer choice is the best one: By making sure the geography, industry, and size are all similar, we ensure that the Discount Rates, which represent risk and potential returns, will also be similar.
That makes it easier to compare the companies because different growth rate expectations will explain most of the differences in the multiples.
The second answer choice is what we want to AVOID: We want
different growth rates to explain the differences in multiples. And the third answer isn’t the best choice because the Discount Rate tends to make a bigger difference than margins or CapEx

Question 13

In theory, Enterprise Value is “capital structure-neutral” because it won’t be affected by changes in Cash, Debt, Equity, and Preferred Stock as long as the total amount of capital stays the same. Why might this principle NOT be true in real life?

Conceptual Questions

Answer 13

a. The tax treatment of each form of capital is different.
b. Debt and Preferred Stock increase the risk of bankruptcy, but Equity does not.
c. Debt and Equity investors have different motivations, and they may want the company to pursue different goals that conflict with each other.
d. The markets may not be efficient, and the company’s capital structure might be mispriced as a result.
Explanation: Everything above is true: Taxes, Bankruptcy Risk, Agency Costs, and Inefficient Markets mean that Enterprise Value may be affected by the company’s capital structure. One specific example is that both the Cost of Debt and the Cost of Equity increase as a company raises more Debt – because more Debt means higher bankruptcy risk, which affects ALL the investors. And those higher costs, in turn, affect the company’s Implied Enterprise Value because they change its Discount Rate.

Question 14

Equity Value represents the value of a company’s Total Assets. If that’s true, why does a
Debt issuance not boost Equity Value? After all, if a company raises $100 in Debt, it gets
$100 in additional Cash, and Cash is an Asset.

Conceptual Questions

Answer 14

Because Common Shareholders’ Equity does not change.
Explanation: This is a trick question because it doesn’t state the correct definition of Equity Value: it represents the company’s NET Assets, but only to common shareholders. Therefore, Common Shareholders’ Equity must change for Equity Value to change. A Debt issuance does not affect CSE, so Equity Value does not change. The first two answers miss the point because they don’t state that Common Shareholders’ Equity does not change, and the last answer makes no sense because Cash and Debt only appear in the Enterprise Value calculation

Question 15

Why do you subtract Equity Investments and add Noncontrolling Interests when moving
from Equity Value to Enterprise Value?

Conceptual Questions

Answer 15

a. Because Equity Investments count as Non-Operating Assets.
d. Because Noncontrolling Interests represent another investor group in the parent company: the minority shareholders of another company that the parent controls.
e. For comparability purposes: metrics like EBITDA and EBIT include 100% of the contributions from majority-owned companies but 0% from minority-owned companies, so Enterprise Value must include 100% of majority-owned companies’ values and 0% of minority-owned companies’ values.
Explanation: The first, fourth, and fifth answer choices are correct. Equity Investments are Non-Operating Assets, and Noncontrolling Interests represent another investor group beyond the common shareholders. Because of how contributions from partially-owned companies show up on the financial statements, you also need to subtract and add these items in the TEV calculation for comparability purposes. The second answer choice is incorrect because Equity Investments are not necessarily liquid assets; in fact, they’re usually not. The third answer is wrong because Noncontrolling Interests don’t “cost” an acquirer anything extra because most acquirers leave them in place, and there’s no requirement to refinance or repay them upon a change of control. And the sixth answer choice is wrong because of the preceding explanations.

Question 16

Which of the following statements express the correct DIFFERENCES between EBIT and
EBITDA?

Conceptual Questions

Answer 16

b. EBIT represents core, recurring business profitability, but EBITDA is more of a
proxy for core, recurring business cash flow from operations.
d. You should use EBIT when you want to reflect companies’ CapEx, at least in
part, but EBITDA when you want to ignore it or normalize for CapEx and D&A.
e. EBITDA is valid for use in TEV / EBITDA multiples under both U.S. GAAP and IFRS,
but EBIT is not valid under IFRS unless you adjust it.
Explanation: The second, fourth, and fifth answer choices are correct:
EBIT is more about profitability, while EBITDA is closer to cash flow, but
they both correspond to a company’s core business and ignore the
impact of capital structure and taxes. This is because EBITDA adds back
the major non-cash charge of D&A, while EBIT does not. The first answer
is wrong because it explains how EBIT and EBITDA are similar, but the
question asks for how they are DIFFERENT. The third answer choice
reverses the correct answer: EBIT, not EBITDA, reflects the partial impact
of CapEx because it deducts Depreciation & Amortization from prior
CapEx. The fifth answer choice is also correct because EBIT deducts only
part of the Lease expense under IFRS (the Depreciation element), so you
need to adjust it if you pair with TEV for an IFRS-based company.

Question 17

How are Unlevered Free Cash Flow and Levered Free Cash Flow different?

Conceptual Questions

Answer 17

a. Unlevered FCF starts with NOPAT, but Levered FCF starts with Net Income to
Common.
b. Unlevered FCF excludes Net Interest Expense, Debt Repayments, and Debt
Issuances, but Levered FCF deducts the Net Interest Expense and Debt
Repayments and potentially adds Debt issuances.
d. Unlevered FCF represents cash flow available to ALL investors, while Levered FCF
represents cash flow available ONLY to common shareholders.
Explanation: The first, second, and fourth answer choices are all correct:
Unlevered FCF completely excludes all income and expenses associated
with Cash, Debt, and Preferred Stock, so you use NOPAT, or EBIT * (1 –
Tax Rate) as the starting point for the calculations. But Levered FCF does
the opposite and includes all of those, so it effectively starts with Net
Income or Net Income to Common (if the company has Preferred Stock).
Unlevered FCF represents cash flow available to all investors, so it
corresponds to Enterprise Value and WACC, whereas Levered FCF
represents cash flow available only to common shareholders, so it
corresponds to Equity Value and Cost of Equity. The third answer is
incorrect because you can calculate both metrics starting with Cash Flow
from Operations – it’s just that with Unlevered FCF, you need to do more
work by adding back the after-tax Net Interest Expense.

Question 18

Why might you add Un(der)funded Pension Obligations in the Equity Value to Enterprise Value bridge?

Conceptual Questions

Answer 18

b. Because the employees that receive the pension payments act like “another investor group” here – the company pays the employees less in the current period in exchange for a promise to pay retirement benefits in the future.
c. Because the Un(der)funded Pensions are Debt-like obligations that accrue interest and require annual payments.
Explanation: The second and third answer choices are correct: The employees to whom these pensions are owed are, effectively, an “investor group” in the company for the reasons stated. The Un(der)funded Pensions are very similar to Debt because they accrue interest and require annual payments from the company. An acquirer does not have to repay Un(der)funded Pensions right away upon acquisition, so the first answer choice is incorrect.

Question 19

Should you add a company’s on-Balance Sheet Operating Leases to its Enterprise Value?

Conceptual Questions

Answer 19

a. Under U.S. GAAP, you could add them or ignore them as long as you’re
consistent with the multiples (if you add them, you need to add back or exclude the Rental Expense in the denominators of TEV-based multiples).
b. Under IFRS, you usually have to add them because companies split the Rental Expense into Interest and Depreciation elements, meaning that EBITDA already adds back the entire Rental Expense.
Explanation: The first and second answer choices are correct for the
reasons stated. Under both accounting systems, you could, technically,
add OR ignore Operating Leases in Enterprise Value, but under U.S.
GAAP, it’s generally easier to ignore them because the Rental Expense is
still listed as-is on the Income Statement. Under IFRS, it’s easier to add
Operating Leases because EBITDA already excludes the entire Rental
Expense, and companies don’t necessarily disclose the portions of
Depreciation and Interest that represent Rent. The third answer is wrong
because the proper treatment is based on comparability in the multiples,
not the Cost of Debt vs. Cost of Leases

Question 20

How is the EBITDA multiple different under U.S. GAAP and IFRS, assuming that you
calculate EBITDA from the Income Statement and Cash Flow Statement and make no
adjustments other than the add-backs for non-recurring charges and D&A for EBITDA?

Conceptual Questions

Answer 20

b. EBITDA pairs with Enterprise Value (TEV) under both systems, but under U.S.
GAAP, you should not add Operating Leases to TEV; you do the opposite under
IFRS.
c. Under U.S. GAAP, EBITDA deducts the full Rental Expense; under IFRS, it adds
back or excludes the full Rental Expense
Explanation: Answer choices #2 and #3 are the correct ones. Under U.S.
GAAP, the Rental Expense appears as a standard Operating Expense on
the IS, reducing both EBIT and EBITDA. Therefore, you do NOT add
Operating Leases in TEV unless you adjust these numbers and add back
the Rental Expense, creating EBITR and EBITDAR instead. Answer choices
#1 and #4 reverse this treatment and mix up IFRS and U.S. GAAP

Question 21

A company issues $100 of Debt and $100 of Common Stock to acquire $100 in PP&E and
issue $100 in Common Dividends. How do the company’s Equity Value (Eq Val) and
Enterprise Value (TEV) change immediately after these events?

Calculations and Scenarios

Answer 21

Eq Val stays the same; TEV increases by $100.
Explanation: The first answer choice is correct. Common Shareholders’
Equity stays the same because it increases by $100 and then decreases by
$100, so Eq Val stays the same as well. That rules out the third and fourth
answers. Net Operating Assets increases by $100 PP&E increases by $100
and no Operational Liabilities change, so TEV increases by $100, making
answer choice #1 the correct one.

Question 22

A company issues $100 of new Debt to acquire an Asset for $100. How do Equity Value
(Eq Val) and Enterprise Value (TEV) change immediately after these events?

Answer 22

Eq Val stays the same; you cannot determine whether or not TEV changes.
Explanation: The fourth answer choice is correct. Common Shareholders’
Equity does not change, so Equity Value cannot change. We don’t know
whether the Asset is Operating or Non-Operating, so we can’t tell how
Net Operating Assets will change. Therefore, we need more information
to determine how TEV will change.

Question 23

A company issues $300 of Preferred Stock and uses $100 of it to issue Common
Dividends and the remaining $200 to purchase additional PP&E. How do Equity Value
(Eq Val) and Enterprise Value (TEV) change immediately after these events?

Calculations and Scenarios

Answer 23

Eq Val decreases by $100; TEV increases by $200.
Explanation: Common Shareholders’ Equity decreases by $100 because
of the Common Dividends, so Eq Val decreases by $100. This finding rules
out answers #1 and #3. PP&E is an Operating Asset, and no Operating
Liabilities change, so Net Operating Assets increases by $200. Therefore,
TEV increases by $200, which makes the fourth answer the correct one.

Question 24

A company raises $200 in Debt to pay for issuances of $100 in Common Dividends and
$100 in Preferred Dividends. How do Equity Value (Eq Val) and Enterprise Value (TEV)
change immediately after these events?

Calculations and Scenarios

Answer 24

Eq Val decreases by $200; TEV stays the same.
Explanation: The second answer choice is correct. Both Common
Dividends and Preferred Dividends reduce Common Shareholders’ Equity,
so it falls by $200, which means that Eq Val decreases by $200 as well.
Net Operating Assets stays the same because Cash, Debt, and CSE are all
Non-Operating, so TEV stays the same.

Question 25

A company issues $300 in Common Stock to acquire another company for a purchase
price of $200. The other company has a Common Shareholders’ Equity of $150. How do
Equity Value (Eq Val) and Enterprise Value (TEV) change immediately after these
events?

Calculations and Scenarios

Answer 25

Eq Val increases by $300, and TEV increases by $200.
Explanation: The fact that the other company has Common Shareholders’
Equity of $150 is irrelevant; Goodwill and Other Intangibles do not factor
into these calculations. The acquirer issues $300 of Common Stock,
boosting Common Shareholders’ Equity by $300. Therefore, Eq Val
increases by $300. Of this $300, $100 remains in Cash on the Balance
Sheet, while $200 is allocated to the acquired company’s Assets (split
between its existing Assets and newly created Goodwill & Other
Intangibles). No Operating Liabilities change, so NOA is up by $200, and
TEV is, therefore, up by $200

Question 26

A company has a Current Equity Value of $250, $50 in Cash, and $100 in Debt. If the
company issues $200 of new Debt and uses $100 of it to repurchase Common Shares
and $100 of it to purchase PP&E, how do Equity Value and Enterprise Value change
immediately after these events?

Calculations and Scenarios

Answer 26

Equity Value = $150; Enterprise Value = $400.
Explanation: The company’s Current Enterprise Value is $250 – $50 +
$100 = $300. If the company raises $200 of new Debt, neither Equity
Value nor Enterprise Value change at first. Once the company uses that
Debt to repurchase $100 of Common Shares, Equity Value declines by
$100, falling to $150, but Enterprise Value stays the same because this is
only a financing event. When the company purchases $100 of PP&E,
Enterprise Value increases by $100, rising to $400, because PP&E is an
Operating Asset, and no Operating Liabilities change, so NOA increases by
$100. Equity Value doesn’t change in that step because Common
Shareholders’ Equity does not change.

Question 27

A company’s Current Equity Value is $200. It has $50 in Cash, $125 in Debt, $25 in
Preferred Stock, and $50 in Unfunded Pensions (contributions into its pension plan are
NOT tax-deductible). It also has Goodwill of $100, Deferred Tax Assets of $50, and,
within the DTA balance, $20 corresponds to NOLs. What is the company’s Current
Enterprise Value?

Calculations and Scenarios

Answer 27

$330.
Explanation: The Goodwill and total Deferred Tax Assets are irrelevant,
so you can ignore that information. Enterprise Value = Equity Value –
Cash – NOLs + Debt + Preferred Stock + Unfunded Pensions = $200 – $50
– $20 + $125 + $25 + $50 = $330. If pension contributions had been taxdeductible, we would have had to multiply the Unfunded Pensions by (1
– Tax Rate)

Question 28

Calculations and ScenariosA Parent Company owns 70% of a Subsidiary Company. The Parent Company’s
standalone Equity Value – EXCLUDING the value of this Subsidiary Company – is $1,000,
its standalone Cash is $100, and its standalone Debt is $200.
The Subsidiary Company’s standalone Equity Value is $500, its Standalone Cash is $50,
and its Standalone Debt is $30.
The Parent Company’s standalone EBITDA is $100, and the Subsidiary Company’s
standalone EBITDA is $40. What are the Enterprise Value and TEV / EBITDA for the
COMBINED company?

Calculations and Scenarios

Answer 28

Enterprise Value = $1,580; TEV / EBITDA = 11.3x.
Explanation: First, calculate the Combined Enterprise Value. When a
Parent Company owns over 50% of a Subsidiary Company, you
consolidate all the financials. So, the Combined Cash is $150, and the
Combined Debt is $230. The Combined Equity Value is $1,000 + 70% *
$500 = $1,350.
Combined Enterprise Value = Combined Equity Value – Combined Cash +
Combined Debt + Noncontrolling Interests.
Combined Enterprise Value = $1,350 – $150 + $230 + 30% * $500 =
$1,580.
Alternatively, you could just add both companies’ Equity Value, Cash, and
Debt figures and use them to calculate the Combined Enterprise Value:
$1,000 + $500 – $100 – $50 + $200 + $30 = $1,580.
Combined EBITDA = $100 + $40 = $140. It’s a simple addition because you
consolidate both companies’ financial statements 100%. Therefore, TEV /
EBITDA = $1,580 / $140 = 11.3x.

Question 29

A Parent Company owns 30% of a Subsidiary Company. The Parent Company’s
standalone Equity Value – EXCLUDING the value of the Subsidiary Company – is $1,000,
and its standalone Net Income is $50.
The Subsidiary Company’s standalone Equity Value is $400, and its standalone Net
Income is $40. What is the COMBINED P / E multiple?

Calculations and Scenarios

Answer 29

18.1x.
Explanation: Start by calculating the Combined Equity Value, which
equals the Parent’s standalone Equity Value plus the value of its stake in
the Subsidiary Company’s Equity. That equals $1,000 + 30% * $400 =
$1,120. You calculate the Combined Net Income in a similar way: $50 +
30% * $40 = $62. So, the Combined P / E = $1,120 / $62 = 18.1x.

Question 30

A company has 1,000 shares outstanding and a current share price of $10.00. It has 10
options outstanding at an exercise price of $5.00. It also has 5 Restricted Stock Units
(RSUs) and 10 convertible bonds at a conversion price of $5.00 and par value of $100.
What is its Diluted Equity Value?

Calculations and Scenarios

Answer 30

$12,100
Explanation: The company’s options are in-the-money because their
exercise price is below the current share price, so the option holders can
exercise the options and create 10 additional shares. The company gets
10 * $5.00 = $50 in proceeds, which it uses to repurchase 5 of those
shares. There are now 5 additional shares outstanding (10 new shares – 5
repurchased).
You add the 5 RSUs as if they were common shares, so now there’s a net
total of 10 additional shares outstanding.
The company’s share price of $10.00 exceeds the conversion price of
$5.00, so the convertible bonds can convert into shares. The shares per
bond equal the par value divided by the conversion price, so $100 / $5.00
= 20 new shares per bond. There are 10 convertible bonds outstanding,
so we get 10 * 20 = 200 new shares. The options, RSUs, and convertible
bonds together create 210 additional shares outstanding, so the diluted
share count is 1,210, and the Diluted Equity Value is $12,100.

Question 31

A company is currently trading at 8x TEV / EBITDA. It wants to sell a division for 5x
EBITDA. Will that sale increase or decrease the company’s Enterprise Value and TEV /
EBITDA?

Calculations and Scenarios

Answer 31

Its Enterprise Value will decrease, but its TEV / EBITDA will increase.
Explanation: The second answer choice is correct. By definition, if a
division of a company contributes actual EBITDA, the division must count
as Operational, which rules out the first answer choice (as EBITDA
excludes income from unrelated side businesses).
Selling an Operating Asset, effectively replacing it with Cash, will reduce
Enterprise Value because the Net Operating Assets will decline. That rules
out the third answer choice. But the company’s TEV / EBITDA will
increase because the division is sold at a lower multiple than the
company as a whole.
To see why, pretend that the company’s total EBITDA is $100, and this
division contributes $20 of that EBITDA. The company’s Enterprise Value
before the sale is, therefore, $800. The company now sells the division
for $100, or 5x EBITDA. After the sale, the company’s Enterprise Value
will decrease to $700, and its EBITDA will decrease to $80. Its new TEV /
EBITDA will be 8.75x, which is higher than the original multiple.

Question 32

A high-growth tech company’s current share price is $50, and its basic share count is
100,000. It issues 1,000 convertible bonds at a conversion price of $75, each of which
may convert into 10 shares of common stock. At the same time, it also uses a “capped
call” transaction to purchase call options on its stock and sell warrants on its stock.
It purchases 10,000 call options at an exercise price of $75, and it sells 10,000 warrants
on its stock to the same counterparty at an exercise price of $100. How do you calculate
the dilution if this company’s share price reaches $120?

Calculations and Scenarios

Answer 32

Assume that the call options offset the dilution from the convertible bonds,
and then apply the Treasury Stock Method, using the $100 exercise price for
the warrants and the $120 current share price.
Explanation: The second answer choice is correct. Companies set up
“capped call” or “note hedge” transactions specifically to offset the
dilution from convertible bonds when the share price reaches the
conversion price; dilution occurs only if the share price goes even higher
and reaches the exercise price of the sold warrants, in which case you
apply TSM using the current share price and the exercise price of the sold
warrants. The first and third answers get this wrong and make it overly
complicated – as long as the number of underlying shares or options are
the same in each transaction, it’s a simple offset, and TSM applies only to
the sold warrants.