In business valuations—especially those conducted for SBA 7(a) loan purposes or during transactions—confusion often arises when changes in capital structure affect the valuation results. This confusion intensifies when a deal shifts from an asset purchase to a stock purchase. Bankers and clients may ask, “Why does the value change if the business hasn’t changed?”

To answer that, we need to distinguish between enterprise value, equity value, and how capital structure—the mix of debt and equity financing—affects each. Importantly, these concepts are rooted in established financial theory, including the Nobel Prize-winning work of Franco Modigliani and Merton Miller.

Enterprise Value vs. Equity Value

Enterprise Value (EV) is the value of a company’s entire operations, independent of how it is financed. It reflects the value of the business to all capital providers: both debt and equity holders.

Equity Value (EQV) is what remains for shareholders after accounting for debt. In a debt-free company, equity value and enterprise value are the same. But when debt is introduced, equity value is the remainder:

Equity Value = Enterprise Value – Debt

Alternatively, Equity Value + Debt = Enterprise Value

Two Approaches to Valuation

Valuations generally use one of two income bases:

• Free Cash Flow to the Firm (FCFF): Before interest payments. Used to value the enterprise. Discounted at the Weighted Average Cost of Capital (WACC).
• Free Cash Flow to Equity (FCFE): After interest and debt repayments. Used to value equity directly. Discounted at the Cost of Equity (Ke).

A Case Study: Asset Purchase vs. Stock Purchase

Let’s consider a debt-free company with the following cash flows:

• FCFF and FCFE (identical in a debt-free firm) = $1,000,000
• Cost of Equity (Ke) = 21%
• WACC (if 80% debt is introduced) = 10% (assuming a 5% cost of debt, 25% tax rate, and 80% debt financing)

Scenario 1: Stock Purchase (No Debt)

In a stock deal, if there is no debt, we use the cost of equity to discount FCFE:

Equity Value = 1,000,000/.21 = $4,761,905

This is also the enterprise value, since there is no debt.

Scenario 2: Asset Purchase (Buyer Uses 80% Debt)

Assume a buyer intends to use 80% debt to finance the acquisition, which introduces a new capital structure. We use FCFF and the lower WACC (due to cheaper debt financing) to estimate enterprise value:

Enterprise Value = 1,000,000/0.10 = $10,000,000 ]

If the buyer uses $8,000,000 in debt, the equity value becomes:

Equity Value = EV – Debt = $10,000,000 – $8,000,000 = $2,000,000 ]

Key Insight: Even though the enterprise value increases with leverage, the equity value shrinks due to the debt burden.

Why the Change in Value? (It’s Not Just The Appraiser’s Opinion)

This is explained by Modigliani and Miller’s Capital Structure Theorem, a foundational theory in finance. M&M demonstrated:

• In a perfect market (no taxes or bankruptcy costs), capital structure doesn’t affect total firm value.
• In the real world, the use of debt increases firm value because of tax-deductible interest (the tax shield).
• However, too much debt increases risk—including bankruptcy and agency costs—eventually reducing firm value. This is known as the trade-off theory. As debt rises, the cost of equity also increases to reflect the higher risk borne by shareholders, per M&M Proposition II.

These aren’t just theories—they won Franco Modigliani the 1985 Nobel Prize in Economics. This is the academic foundation behind this issue.

So What Happens Post-Transaction?

In the asset purchase example above, if the buyer uses 80% debt to finance the acquisition:

• Enterprise Value is $10M (based on the lower WACC from the new capital structure).
• Equity Value is $2M because debt holders claim $8M of the value.
• The risk to equity holders increases, raising their required return (cost of equity) due to the higher financial leverage.

For SBA 7(a) loans, this shift in capital structure is critical. Lenders must assess whether the business can service the debt, as higher leverage increases risk but may improve tax efficiency. SBA requirements, such as personal guarantees or asset-based collateral, often tie directly to the valuation and financing structure, particularly in asset purchases where tangible assets are pledged.

Key Takeaways for Bankers

1. Capital Structure Matters – Debt lowers WACC (initially), increasing EV, but reduces equity value.
2. Transaction Type Drives the Methodology – Asset purchases use FCFF and WACC. Stock deals use FCFE and cost of equity.
3. Theory Supports This – The value change isn’t a judgment call; it’s grounded in Nobel-recognized financial theory.

Appraiser are not just making assumptions—they’re applying the same logic used by economists who won the Nobel Prize. Leverage can increase the total value of the business by reducing taxes, but it also increases the risk to the buyer. That’s why the value of the stock changes when the structure of the deal changes.