MSE608C – Engineering and Financial Cost Analysis

Financing a Business

Business Structures

• Sole Proprietorship

• Partnerships

• Corporations– S Corporation– Private– Publicly traded

Financing a Business

• Two Sources of Cash– Debt

• Commercial Loans• Bonds• Leasing• Trade Credit

– Equity• Personal Savings• Private Investors• Venture Capitalist• Stocks• Retained Earnings

Debt Financing

• Commercial Loans

• Bonds

• Leasing

• Trade Credit

Equity Financing

• Personal Savings

• Private Investors

• Venture Capitalist

• Stocks

• Retained Earnings

Stocks• Common Stock

– No fixed maturity– No obligation of payment of dividends– Right to vote for the directors

• Preferred Stock– No fixed maturity– An obligation to receive dividends– Convertible to Common Stock

• Options– Strike price = stock price on date option is granted– A claim on the Equity ownership that will dilute the

ownership position.

Which Is Best?

• Risk– Debt more risky than Equity

• Costs– Equity is more costly than debt financing

– Publicly-traded companies have higher costs associated with complying with accounting regulations.

• Control of the Company– Equity financing usually requires giving up some

management control of the business.

Debt Leverage

• Long-term Debt to Total CapitalizationLong-term Debt to Total Capitalization = Non-current liabilities

Total Capitalization

– Total Capitalization = Long-term Debt + Owners’ Equity

• Highly (Debt) Leveraged companies will have wider swings in Earnings Per Share (EPS)– Fewer owners to share the wealth when business is good

– Interest payment have a bigger effect on Net Income when business is poor

Assessment

• What are the two methods for financing a business?

• What are the differences between an Angel Investor and a Venture Capitalist?

• You are starting a online Internet company. What do you think will be you sequence of financing, and why?

Overstating Revenues

• Selling to Related Entities– The party must be an “arms length”

• Stuffing the Channels– Excessive quantities to distributors/retailers– Extended credit terms

• Installment sales at Low Interest Rates– Artificially low interest rate to calculated time-

adjusted cash flows = higher recognized Revenues

Overstating Revenues

• Using funds from Over-funded Reserves– Reserves obligation will fluctuate– Using over-funded Reserves can result in

under-funding at later accounting periods.

• Treat Nonrecurring Dispositions as Ordinary Income– “Below-the-line” gains are nonrecurring– Can over-state Income from normal business

operations

Overstating Revenues

• Record Income for Future Services– “Bundled price” includes deferred expenses– May underestimate value of future services to

over-state current Revenues

Understating Expenses

• Unrealistic Depreciation/Amortization– Allowable to use a different method for

financial reports from Tax (IRS) reporting

• Capitalize Questionable Expenses– Capitalization or Expense?– Capitalization = deferred expenses– Match Expenses to Revenues

Understating Expenses

• Ignore the cost of Stock Options– When exercised

• Increases outstanding shares and affects EPS

• Loss of value to company if strike price below market price

– How to value?• Must have some value to have meaning to recipient

• Valuation methods require making assumptions

• Sarbanes-Oxley requirements

Understating Expenses

• Delay the Accrual of Expenses– Reserve accounts– Contra-asset accounts

• Overstate Assets or Understate Liabilities

• Delay Recognizing Declining Asset Value

Overstate Assets or Understate Liabilities

• Delay Recognizing Declining Asset Value– Dressing up the Balance Sheet

• Accounts Receivable and Allowance for Doubtful Accounts

• Loans Receivable and Allowance for Bad Debt• Inventory and Allowance for Obsolete Inventory• Fixed Assets and writing off obsolete assets• Investments and unrealistic market valuation

– Conservatism requires the Accountant to understate assets

Failure to Disclose Liabilities

• Must disclose all liabilities– Pending lawsuits– Pension costs– Toxic cleanup– Deferred Executive compensation

• Use Unconsolidated Debt– Offload debt from one affiliated to another– Dresses up Balance Sheet– Relationships must be reported in footnotes

What Did They Do Wrong?

• WorldCom (Bernie Ebbers)– $3.8B in operating expenses booked as Capital

Expenditures.• Fee paid to other telecommunication companies for

use of their telephone networks.

What Did They Do Wrong?

• Adelphia– John, Timothy and Michael Rigas + others

• Company was personal “piggy bank”– John Rigas withdrew $1M per month

– $3B line of credit for John Rigas but the company responsible if default

– Hid $2.3B of debt in off-Balance Sheet affiliates

What Did They Do Wrong?

• Enron– Huge losses in two investments backed by Enron stock,

Avici and New Power, not reflected in public filings– Andrew Fastow ran two partnerships that were treated

as separate companies, LJM1 & LJM2• Financed by Merril Lynch & Co.• Purchased three Nigerian barges (assets) from Enron at end of year to

boost profits.• Secret promise to repurchase barges later at a higher price.

– Lay unfairly represented Enron’s true financial condition to investors.

What Did They Do Wrong?

• Fannie Mae– Doctored earning over 6 years

• Did not record Revenues in the period they occurred.

– Misstated earnings by $10.6B

– Hundreds of million in bonuses

– Purchased some of their own loan packages

Assessment

• What are the three generic types of business structures?

• What is the problem with using money in an over-funded Reserve (contingency) account? Is it legal?

• If you sell to your own company can you recognize this as Revenues? What principle is considered in this case?