MSE 608 C Engineering and Financial Cost Analysis

MSE 608 C – 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 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 timeadjusted 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? • World. Com (Bernie Ebbers) – $3. 8 B 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 $1 M per month – $3 B line of credit for John Rigas but the company responsible if default – Hid $2. 3 B 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, LJM 1 & LJM 2 • 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. 6 B – Hundreds of million in bonuses – Purchased some of their own loan packages

Assessment • What are 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?