Question

Company A and Company B are similar companies operating in the same industry.

Initially, both Company A and Company B have an enterprise value of $400 million – that is to say, the value of the operating business is $400 million. Note that the enterprise value is the same as the market value of equity (Share price x number of shares outstanding = $400 million) for Company A and different from market value of equity for Company B.

Company A has no net debt and Company B has $200 million in net debt. (Note that Company B could have $100 million in cash and $300 million in debt or simply no cash and $200 million in debt. It’s the net debt that matters in this analysis.)

Industry conditions change and the value of all businesses in this industry sector doubles overnight. That means the enterprise value (the value of the operating business) for both companies doubles.

What is the return earned by equity investors in Company A? Company B?

Company A Company B Company A Company B $200 mm net debt $200 mm net debt Initial market valuation = $400 million each Later market valuation = $800 million each

Answer 1

Answer:

Company A = Initial Enterprise value = $400m

Enterprise value is equal to equity value + Debt, but debt is zero. So equity value = enterprise value

Company A equity value = $400m

Now Company A valuation = $800m

Return earned by equity investors = (E1- E0)/E0

= (800-400)/400 = 100%

Company B = Initial Enterprise value = $400m

Enterprise value is equal to equity value + Debt, but debt is $200m

Equity value = $400-$200 = $200m

Now Company B valuation = $800m which includes $200m debt

Equity Value = $800m-$200m

= $600m

Return earned by equity investors = (E1- E0)/E0

= (600-200)/200 = 200%

The returns for company B has magnified due to debt in the capital structure