The Daily Technical #61: How is the cost of equity calculated?

Good morning. Welcome to the 61st edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
When calculating enterprise value, why do we add net debt? 

To effectively answer this question, focus on the interplay between cash and debt on a company’s balance sheet.

The core concept is that a company's available cash can be used to reduce its outstanding debt. This results in a more accurate reflection of a company's leverage and overall financial health by using net debt instead of gross debt.

This helps to represent a more realistic view of a company’s value for potential investors.

Common Mistakes

1. Stating that net debt is added to the calculation without explaining why cash is netted against debt. Make sure to mention that cash can be used to pay down debt, which is why cash is subtracted, resulting in net debt being added to enterprise value.

2. Neglecting the potential flexibility cash provides in managing a company’s debt. When explaining net debt, mention that keeping cash on hand offers the company financial agility

TL;DR

• Net debt represents total debt minus cash and cash equivalents.

• Cash can offset debt; netting it from debt gives a clearer picture of a companies financial leverage.

• Enterprise value uses net rather than gross to reflect a realistic company valuation.

TODAY’S QUESTION
How is the cost of equity calculated?

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THAT’S A WRAP
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