Why does FCFE increase when a firm borrows money?
Starting with the basic accounting equation, A = E + L. Let's imagine that the firm issues traded bonds as debt and all its assets are at market values, tangible etc, this would mean that E = Market Cap. The FCFE is defined as CFO - Investing Cash flow + Net Borrowing. When a firm borrows, it's liabilities and assets increase, no doubt there, but why would equity increase? This just doesn't make any sense to me, a company can't increase it's market cap by the amount of borrowing by borrowing more, this is utter nonsense.
What said anything about market cap going up more? It's just cash flow to equity holders has gone up, whether equity holders will do the right thing with those extra cash flow is a different question.
- Taking on debt will not increase Market Capitalisation, it will only unlock a new cash flow for equity holders.
- Shareholder's Equity ≠ Market Capitalisation.
- Each item in the accounting equation is recorded at book value, not market value.
Equity will not increased based on the balance sheet principles - as you said assets and liabilities increase, which cancels out. Same with FCFE, which is CFO - investing outflow (you've invested in an asset hence cash outflow) + newly the issued debt, hence FCFE does not change (in the simplest case)
There's no cash outflow here. OP didn't say anything about them using the issuance proceeds to buy fixed capital.
OP is confused that FCFE would increase equity for some reason. This isn't the case.
It just increases FCFE for the very simple reason that FCFE is the operating cash a business has left over after paying its debt/investment obligations. In other words, a proxy for what it can distribute to equity holders. If a business issues debt and gets cash for it, they could technically turn around and use that cash to pay a dividend or buy back shares (and this isn't unheard of), thus debt issuance increases FCFE.
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