How Events Impact Equity Value and Enterprise Value

Question 1

How Events Impact Equity Value and Enterprise Value

Answer 1

These questions are simple to answer if you remember the two key rules:

1) Does Common Shareholders’ Equity (CSE) change? If so, then Equity Value changes by the amount that CSE changes.

If not, then Equity Value does not change. You can also think of this as, “Do Net Assets change?” but be careful because if there are Noncontrolling Interests or Preferred Stock, Net Assets no longer equals CSE!

Items that affect CSE include Net Income, Dividends, Stock Issuances, and Stock Repurchases.

2) Do Net Operating Assets (NOA) change? If so, then Enterprise Value will change by the amount that NOA changes.

It doesn’t matter which investor group was responsible because Enterprise Value reflects all investors. You could also get questions about how valuation multiples change, but these questions are a bit pointless because the historical financial metrics (Revenue, EBITDA, Net Income, etc.) will not change immediately after a capital raise, acquisition, or another event takes place.

So, you can answer any question about valuation multiples by explaining what happens to Equity Value and Enterprise Value (e.g., if TEV increases, then TEV / EBITDA also increases).

Question 2

1. A company issues $200 in Common Shares. How do Equity Value and Enterprise Value change?

Answer 2

CSE increases by $200, so Eq Val increases by $200. NOA does not change because neither Cash nor CSE is operational, so TEV stays the same. Alternatively, in the TEV formula, the extra Cash offsets the higher Equity Value.

Question 3

2. A company issues $200 in Common Shares, and it uses $100 from the proceeds to pay Dividends to the common shareholders. How does everything change?

Answer 3

CSE increases by $100 after both changes, so Eq Val increases by $100.

NOA does not change because neither Cash nor CSE is operational, so TEV stays the same.

Alternatively, in the TEV formula, the extra Cash offsets the higher Equity Value.

Question 4

3. The company decides to use the $200 in proceeds from new Common Stock to acquire another business for $100 instead. How does everything change?

Answer 4

CSE increases by $200 from this issuance, so Eq Val increases by $200.

Of this $200 in proceeds, $100 remains in Cash, and $100 is allocated to Acquired Assets from the other business.

These Acquired Assets are Operating Assets, and no Operating Liabilities change, so NOA increases by $100. TEV, therefore, increases by $100.

Question 5

4. What if the company uses that same $100 from new Common Stock to acquire an Asset rather than an entire company?

Answer 5

CSE still increases by $200, so Eq Val is up by $200.

If this Asset is considered “Operating” or “Core,” such as a factory, then NOA increases by $100, so TEV also increases by $100. If not – for example, the Asset is a short-term investment – then NOA does not change, and TEV stays the same.

Question 6

5. What happens if this company issues $200 in Debt to fund a $100 Asset acquisition instead?

Answer 6

The main difference is that Eq Val no longer changes because CSE does not change as a result of a Debt issuance. If this $100 Asset is Operational, NOA increases, so TEV increases by $100; if not, TEV stays the same.

Question 7

6. A company issues $200 of Debt to fund a $200 Equity Purchase Price acquisition of a company with $150 in Common Shareholders’ Equity.

How do Equity Value and Enterprise Value change, considering that the acquirer must create Goodwill?

Answer 7

The $50 of Goodwill here does not affect anything because Goodwill is an Operating Asset. $200 of Acquired Company Assets vs. $150 of Acquired Company Assets and $50 of Goodwill make the same impact on both Eq Val and TEV.

This $200 Debt Issuance does not affect CSE, so Eq Val stays the same.

TEV increases by $200 because NOA increases by $200 (Operating Assets increase by $200, and no Operating Liabilities change).

Question 8

7. A company issues $100 in Preferred Stock to purchase $50 of PP&E. How do Equity Value and Enterprise Value change?

Answer 8

CSE does not change because Preferred Stock issuances flow into Preferred Stock within Equity, not Common Shareholders’ Equity. Therefore, Eq Val stays the same. NOA increases by $50 because the PP&E is an Operating Asset, and no Operating Liabilities change, so TEV increases by $50.

Question 9

8. Now the company issues $100 in Preferred Stock to repurchase $50 of Common Stock. How do Equity Value and Enterprise Value change?

Answer 9

CSE decreases by $50 because of this repurchase, so Eq Val decreases by $50.

NOA does not change because Cash, Preferred Stock, and CSE are all Non-Operating, so TEV stays the same.

Question 10

9. A company issues $150 of Debt and $50 of Common Stock to acquire $175 of PP&E and $25 of Short-Term Investments. How do Equity Value and Enterprise Value change?

Answer 10

CSE increases by $50 because of the Common Stock Issuance, so Eq Val increases by $50. The $175 of PP&E counts as an Operating Asset, and no Operating Liabilities change (Debt is Non-Operating), so NOA increases by $175, and TEV also increases by $175.

Question 11

10. Current Equity Value represents the Market Value of ALL Assets.

But if that’s the case, why doesn’t a $100 Debt issuance boost Equity Value?

The company receives $100 in extra Cash from this issuance, which should boost its Total Assets.

Answer 11

This is a trick question because the interviewer makes two mistakes in the premise:

1) Equity Value represents Net Assets, not Total Assets.

2) And Current Equity Value represents the Net Assets’ market value only to Equity Investors.

So, Eq Val does not change in this scenario because Common Shareholders’ Equity does not change, so nothing related to point #2 changes. And Net Assets doesn’t even change, going along with point #1.

Question 12

11. A company purchases $100 of Inventory using Cash. How do Equity Value and Enterprise Value change?

Answer 12

There are no changes on the Income Statement in this initial step because the Inventory has not yet been sold.

On the Balance Sheet, CSE stays the same in this initial step, so Eq Val stays the same.

NOA increases by $100 since Inventory is an Operating Asset, and no Operating Liabilities change, so TEV increases by $100.

Question 13

12. Now assume the Inventory is sold for $200 and walk me through how the entire process from beginning to end affects Equity Value and Enterprise Value.

Answer 13

On the Income Statement, Revenue is up by $200, and Pre-Tax Income is up by $100 (due to the $100 of Inventory now being recognized as COGS). Net Income increases by $75 at a 25% tax rate.

On the CFS, Net Income is up by $75, and there are no other changes (Inventory went up and now goes down), so Cash is up by $75 at the bottom.

On the Balance Sheet, Cash is up by $75 on the Assets side, and CSE is up by $75 on the L&E side.

Since CSE is up by $75, Eq Val increases by $75.

NOA does not change because Cash is not an Operating Asset and no Operating Liabilities change, so TEV stays the same.

Intuition: This 2-step process represents the company generating Net Income and letting it sit in Cash; that process does not make its core business more valuable, so TEV does not increase.

Question 14

13. A company collects $200 of cash from a customer upfront for a service that it has not yet delivered. How do Equity Value and Enterprise Value change?

Answer 14

This change is recorded as a $200 increase in Cash on the Assets side of the Balance Sheet, and a $200 increase in Deferred Revenue on the L&E side.

CSE does not change because there’s no Net Income generation yet, and there are no Dividends, Stock Issuances, or Stock Repurchases, so Eq Val stays the same.

NOA decreases by $200 because the Deferred Revenue is an Operating Liability, and no Operating Assets change. Therefore, TEV decreases by $200.

Question 15

14. Now, the company delivers the service to the customer and recognizes the $200 as Revenue, along with $100 in Operating Expenses. Walk me through how the entire process from beginning to end affects Equity Value and Enterprise Value.

Answer 15

On the IS, Pre-Tax Income is up by $100, and Net Income is up by $75 at a 25% tax rate. On the CFS, Net Income is up by $75, and nothing else changes (DR went up and now goes down), so Cash is up by $75.

On the BS, Cash is up by $75 on the Assets side, and CSE is up by $75 on the L&E side.

Since CSE is up by $75, Eq Val increases by $75. NOA does not change because Cash is Non-Operating, and no Operational Liabilities have had a cumulative change, so TEV stays the same.

Intuition: This 2-step process represents the company generating Net Income and letting it sit in Cash; that process does not make its core business more valuable, so TEV does not increase.

Question 16

15. A CEO finds $100 of Cash on the street and adds it to the company’s bank account. How do Equity Value and Enterprise Value change?

Answer 16

This event would be recorded as a $100 Extraordinary Gain on the Income Statement.

If you ignore Taxes completely, Net Income increases by $100, Cash increases by $100, and on the Balance Sheet, Cash is up by $100 on the Assets side, and CSE is up by $100 on the L&E side.

CSE is up by $100, so Eq Val increases by $100.

NOA does not change because no Operating Assets or Liabilities change, so TEV stays the same.

If you factor in Taxes and assume a 25% rate, Net Income and Cash increase by $75 instead, so Eq Val increases by $75, and TEV remains the same.

TEV would change only if you assumed that the Extraordinary Gain does not affect Cash Taxes, in which case the DTA would decrease by $25, reducing TEV by $25 (we don’t recommend mentioning this in interviews because it’s more advanced and will lead to harder questions). Intuition: “Finding” a Non-Operating Asset on the street does not make a company’s core business more valuable.

Question 17

16. A company experiences a disaster at one of its factories and records a $100 PP&E Write-Down.

It also decides to issue $50 in Common Stock to get the funds required to replace this factory in the future.

How do Equity Value and Enterprise Value change?

Answer 17

The PP&E Write-Down reduces Pre-Tax Income by $100 and Net Income by $75 at a 25% tax rate.

On the CFS, Net Income is down by $75, but the Write-Down is non-cash, so you add back $100.

You also reflect the $50 Stock Issuance in CFF, so Cash at the bottom increases by $75. (We’re ignoring Cash vs. Book Taxes in this question and assuming the Write-Down is deductible for both, for simplicity.)

On the BS, Cash is up by $75, and Net PP&E is down by $100, so the Assets side is down by $25. The L&E side is also down by $25 due to the $75 Net Income reduction and $50 Stock Issuance.

CSE is down by $25, so Eq Val is down by $25.

NOA is down by $100 due to the $100 PP&E Write-Down, and no Operating Liabilities change, so TEV decreases by $100.

Intuition: Changes to Operational line items can affect both TEV and Eq Val, but the impact on Eq Val may be “reduced” if the company also changes its capital structure at the same time.

Question 18

17. A company has excess Cash. How do Equity Value and Enterprise Value change if the company uses the Cash to repay Debt vs. repurchase Common Stock?

Answer 18

NOA does not change in any case because nothing here is operational, so TEV stays the same.

In the first case – Debt repayment – CSE does not change because Debt issuances and repayments do not affect it, so Eq Val does not change.

In the second case – a Common Stock repurchase – CSE decreases, so Eq Val decreases

Question 19

18. A company issues a press release indicating that it expects its revenue to grow at 20% rather than its previous estimate of 10%. How does everything change?

Answer 19

This change relates more to the company’s Implied or Intrinsic value. Since the company expects higher sales growth, both its Implied Enterprise Value and Implied Equity Value will increase because they are both based on the company’s expected future cash flows.

Current Eq Val and Current TEV may also increase if the company’s share price instantly jumps up, but you can’t link the change to one specific line item on the Balance Sheet changing; there won’t be an immediate change on the BS right after this announcement.