Intuitively, the first answer that pops into the head is buy the company with low leverage as we can add debt to make a profit as the cost of debt is lower than that of cost of equity. However, to buy any company investors need to pay a premium on the value of equity which makes a significant difference to the purchase price of the company. Let’s work with a case study to drive the point home.
To buy any company the investor needs to pay a premium, Let’s assume a 30% premium which is customarily the real-life average of what investors pay.
Assuming two companies are for sale – all else being equal the only difference between the two are the capital structures. Company A is on sale with an EV of £100m - £80m of debt and £20m of equity. Company B is on sale also with an EV of £100m but has £20m of debt and £80m of equity. The equity investors are likely going to want a premium of 30%. This translates into a tag price of £106m for company A (£80m Debt + £26m (£20m*1.3)) versus a tag price of £124m for company B (£20m of debt and £104m of Equity (£80m*1.3). Therefore, investors would chase company A - Kapish?
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