The IBD interview question we’re going to go over today is “How does raising debt affect a company’s P/E multiple?” This is a somewhat challenging question often asked by Goldman Sachs San Francisco. We’ve seen this question being asked to Summer Analyst and Full-Time Analyst candidates for the GS SF office. Here’s how you can craft your answer.
“The impact is indeterminate. When a company raises debt, there are factors pushing up the P/E multiple but there are also factors pushing it down.
For example, when a company raises debt, debt becomes a greater proportion of its capital structure. So it gets a higher weighting when calculating WACC. Since Cost of Debt is cheaper than Cost of Equity, that will reduce WACC, which will increase Enterprise Value. That increase in Enterprise Value flows down to Equity Value, which pushes up the P/E multiple. But on the other hand, the debt could come with restrictive covenants, which could limit the company’s ability to reinvest in future growth. That could push the P/E multiple down.
And so raising debt wouldn’t definitively increase or decrease P/E multiple. It varies on a case-by-case basis.”
In short, that’s how you can answer the question: “How does raising debt affect a company’s P/E multiple”. It depends on the situation and varies from company to company. You can learn more about this particular question here. The biggest mistake candidates make for this question is by sticking to a firm stance that raising debt would increase or decrease the multiple.