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
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Commercial Loans
Bonds
Leasing
Trade Credit
– Equity
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Personal Savings
Private Investors
Venture Capitalist
Stocks
Retained Earnings
Debt Financing
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Commercial Loans
Bonds
Leasing
Trade Credit
Equity Financing
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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
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
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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?