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?