Enterprise Value?

[777888]

Enterprise Value can be thought of as the purchase price of an enterprise and is being calculated as follows:
Enterprise Value = Equity (or Market Capitalization) + Debt - Cash

Now I am so confused and have 2 questions:

1) Why should we add debt rather than subtracting it?
If a firm has more debt, shouldn't the selling price be lower because any one who purchases the firm would have to assume this debt and pay it off in the future? How can the selling price be higher when the company has more debt as opposed to less debt?

2) Why should we subtract cash rather than adding it?
If a firm has more cash, shouldn't the selling price be higher because any one who purchases the firm would get this large amount of cash, in addition to the acquiring the firm? How can the selling price be lower if the company has more cash as opposed to less cash?

I'm so confused when I think of it in terms of the following example:

Let's say we want to purchase Company A. Suppose Company A has the following balance sheet right before being purchased.
Cash = 1M
Other assets = 9M
Total assets = 10M

Debt = 2M
Total liabilities = 2M

Let's say we pay X dollars to purchase Company A. After being purchased, I imagine Company A's balance sheet would remain exactly the same, i.e. cash of 1M still sits there and we have assumed the debt of 2M, to be repaid in the future. Basically, we have assumed Company A's balance sheet.

I guess the purchase price (X) here would correspond to the Enterprise Value as defined above. But something just doesn't make sense to me.

Hopefully someone can explain/clarify. Any help would be greatly appreciated!

 

[Triest123]

Enterprise Value can be thought of as the purchase price of an enterprise and is being calculated as follows:
Enterprise Value = Equity (or Market Capitalization) + Debt - Cash
.
Hopefully someone can explain/clarify. Any help would be greatly appreciated!

1) Why should we add debt rather than subtracting it?

=> The selling price of the acquired company is the amount that the acquirer (buyer) actually paid to the shareholders of the acquired company.

To the acquirer, however, the amount paid for buying the company is not the actual purchase price as it needs to take over the debts of the acquired company.

In other words, the acquirer not only pay money to the shareholders of the acquired company but have to bear the debts of the acquired company. It is also the costs of the acquirer. So the actual purchase price should include the costs of such debts.


2) Why should we subtract cash rather than adding it?
If a firm has more cash, shouldn't the selling price be higher because any one who purchases the firm would get this large amount of cash, in addition to the acquiring the firm? How can the selling price be lower if the company has more cash as opposed to less cash?

=> If the acquirer has paid money to the shareholders of the acquired company (i.e. the selling price of the acquired company), all the acquired company's cash will belong to the acquirer.

To the acquirer, such cash can be viewed as the reduction of the actual purchase price of the acquired company.

 

[Triest123]

I'm so confused when I think of it in terms of the following example:

Let's say we want to purchase Company A. Suppose Company A has the following balance sheet right before being purchased.
Cash = 1M
Other assets = 9M
Total assets = 10M

Debt = 2M
Total liabilities = 2M

Let's say we pay X dollars to purchase Company A. After being purchased, I imagine Company A's balance sheet would remain exactly the same, i.e. cash of 1M still sits there and we have assumed the debt of 2M, to be repaid in the future. Basically, we have assumed Company A's balance sheet.

=> The X dollars is NOT the Enterprise Value, it just refer to the money paid to the shareholders of the acquired company (i.e. the selling price) but NOT the actual purchase price of the acquired company.

 

[777888]

I'm so confused when I think of it in terms of the following example:

Let's say we want to purchase Company A. Suppose Company A has the following balance sheet right before being purchased.
Cash = 1M
Other assets = 9M
Total assets = 10M

Debt = 2M
Total liabilities = 2M

Let's say we pay X dollars to purchase Company A. After being purchased, I imagine Company A's balance sheet would remain exactly the same, i.e. cash of 1M still sits there and we have assumed the debt of 2M, to be repaid in the future. Basically, we have assumed Company A's balance sheet.

=> The X dollars is NOT the Enterprise Value, it just refer to the money paid to the shareholders of the acquired company (i.e. the selling price) but NOT the actual purchase price of the acquired company.

Thanks!

When we talk about the value of a company, are we referring to its net worth (i.e. equity)? To me, the value of the company is simply the market capitalization as it's the amount of money we have to pay for the acquisition. If we buy all of the shares, then we own 100% of the company, right? That's the value of the company.

Now I don't really understand the concept of Enterprise Value and why we would have to add Debt to the value of the company. If a company has more debt, why would it worth more? Why would we have to pay more for the acquisition AND take over the higher debt that we'll have to repay in the future?

(I'm assuming the balance sheet of Company A is identical right before and after the acquisition.)

 

[777888]

Let's say company A has the following balance sheet right before being acquired:
Cash = 1M
Other assets = 9M
Total assets = 10M

Long Term Debt = 2M (let's assume this debt is due in year 2020)
Total liabilities = 2M

We want to buy company A and so would like to determine the value of the company. To me, buying a company means taking over its entire balance sheet, i.e. take over the entire balance sheet of Company A right before being acquired. Its balance sheet remains identical right after paying for the acquisition.

I know company A has a debt of 2M, but it's not due until year 2020, so it just stays on the balance sheet after the acquisition until 2020. Having said this, why should we add debt to Enterprise Value to pay more to acquire this company, AND in addition to this, assume the 2M debt that is due in year 2020?

I would say "market capitalization" is the fair price of the company and it's the price I would pay to take over the company. I wouldn't pay anything more, and I certainly won't pay more just because company A has more debt. In fact, I may pay less because I would have to assume the 2M debt that is due in year 2020.

I'm very puzzled. Any help would be greatly appreciated!

 

[777888]

Well unless you tell me that company A's balance sheet would change to the following right after the acquisition (i.e. not taking over company A's existing balance sheet as is), then in this case I would consider the Enterprise Value to be a fair price for the purchase.

Cash = 0M
Other assets = 9M
Total assets = 9M

Debt = 0M
Total liabilities = 0M

But the 2M is Long Term Debt and isn't due until year 2020. Why would the balance sheet change just because the company is being acquired?

 

[DerrickWD]

You have to stop thinking of enterprise value as equivalent to the purchase price of the company. Enterprise value is one way to interpret the true cost of buying a business.
We can all intuitively realize that taking on debt is costly, so the more debt, the more cost recognized within enterprise value. Gaining cash upon purchase of a company has the effect of a discount, or a rebate, so any cash the acquirer gains access to by purchasing the company reduces the cost of the transaction.
For instance, if you buy a company for $10,000,000, but that company has $2,000,000 in cash that you gain access to upon purchase, in effect that purchase only cost you $8,000,000. Just like if you buy a blender for $100 but get an immediate $20 rebate, in effect the blender only cost you $80.

If upon buying that blender you were saddled with $100 extra dollars of debt, then in some sense, buying the blender will cost you $180. ($100 sale price - $20 cash rebate + $100 debt incurred.). Sure the debt doesn't really cost you until later, but it might be important to consider how much that extra debt will cost you in the future, hence enterprise value calculations.

 

[777888]

Thanks for explaining this! It's very helpful.

Is it true that a company can increase it's Enterprise Value by, for example, borrowing more money (i.e. taking more debt)?

 

[777888]

If a company can increase it's Enterprise Value simply by borrowing more money (i.e. taking more debt), doesn't that make Enterprise Value kind of an artificial thing that can be easily manipulated?

 

[Triest123]

If a company can increase it's Enterprise Value simply by borrowing more money (i.e. taking more debt), doesn't that make Enterprise Value kind of an artificial thing that can be easily manipulated?

=> Enterprise value also known as takeover value which focus on the "total value" of a business (i.e. the total assets value) rather than "the net worth of a company".
It provides an another way for the acquirer to select which company should be purchased.

If two companies have both maket capitalization, the acquirer should purchase the company which has a lower enterprise value (i.e. the takeover value)

(Market capital capitalization = market share price x total shares outstanding,
which refer to the net worth of an company at market value)