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 changes from an asset purchase to a stock purchase. Bankers and clients alike 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

Two Approaches to Valuation

Valuations generally use one of two income approaches:
– Free Cash Flow to the Firm (FCFF): Before interest payments. Used to value the enterprise. Discounted at the 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) = 25%
– WACC (if 80% debt is introduced hypothetically) = 10%

Scenario 1: Stock Purchase (No Debt)
Equity Value = $1,000,000 / 0.25= $4,000,000 (before discount for lack of marketability)
This is also the enterprise value, since there is no debt.

Scenario 2: Asset Purchase (Buyer Uses 80% Debt)
Enterprise Value = $1,000,000 / 0.10 = $10,000,000
Equity Value = $10,000,000 – $8,000,000 (debt) = $2,000,000

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

What’s happening here 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.
– But in the real world, the use of debt increases firm value because of tax-deductible interest.
– However, too much debt increases risk and costs, eventually reducing firm value—this is known as the trade-off theory.

These aren’t just theories—they won Franco Modigliani the 1985 Nobel Prize in Economics. This is the academic foundation behind what you’re telling your clients.

So What Happens Post-Transaction?

If the buyer uses 80% debt to finance the acquisition:
– Enterprise Value is $10,000,000 (assuming no changes in operations).
– Equity Value drops to $2,000,000 because now debt holders claim the majority of value.
– The risk to equity holders increases, which means their required return rises.

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.

These are not just wild assumptions—this is 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.