Making Informed Judgments
Part 5
Risks and Rewards Application:
Shopping Mall Exercise and 2007-2009 Credit Crisis
®
Navigating Accounting, G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name].
1
Menu

Shopping Mall Exercise:
 Two shareholders
 One shareholder and one bank loan
 One shareholder and two bank loans

Closing thoughts
2
View in Slide Show Mode > click hyperlink.
Mall Exercise: Two Shareholders
Things You Need to Know
 On 01/01/2009, ABC Company is formed and issues stock
to two shareholders
 $200 worth of stock to shareholder A (20%)
 $800 worth of stock to shareholder B (80%)
 On 01/02/2009, ABC purchases land for $1,000
 Land is next to a planned shopping mall
 Mall still needs approval from regulators
 ABC expects to resale the land at the end of 2009:
 For $2,000 if the shopping mall is approved by regulators
 For $500 if the shopping mall is not approved
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3
Mall Exercise: Two Shareholders
Things You Need to Know
 On 12/28/2009, ABC learns whether the mall is approved
or not
 On 12/30/2009, ABC sells the land
 For $2,000 if the mall is approved
 For $500 if the mall is not approved
 On 12/31/2009, ABC distributes the cash from the sale of
the land to its shareholders. The payoffs are in
proportion to the shareholder’s equity stake in the
company.
 ABC is located in a country where there are no taxes.
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4
Mall Exercise: Two Shareholders
Question: Part a1
 Determine ABC’s balance sheet possibilities:
ABC Company Consolidated Balance Sheet
12/30/2009, Pre Payoffs
If Mall
approved
If Mall not
approved
1/2/2009
1/1/2009
After land
purchased
After
financing
Assets
Cash and equivalents
PP&E
Total assets
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
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Mall Exercise: Two Shareholders
Solution: Part a1
ABC’s balance sheet possibilities:
Consolidated Balance Sheet
12/30/2009, Pre Payoffs
Mall
approved
Assets
Cash and equivalents
Mall not
approved
1/2/2009
After land
acquired
1/1/2009
After
financing
$0
$1,000
PP&E
$1,000
$0
Total assets
$1,000
$1,000
$0
$0
$1,000
$1,000
$0
$0
$1,000
$1,000
$1,000
$1,000
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
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Mall Exercise: Two Shareholders
Question

How did the land purchase affect the balance sheet?

Why would an investor want to know about this change?
7
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Mall Exercise: Two Shareholders
Question: Part a2
 Determine ABC’s shareholders’ gain/loss possibilities:
SHAREHOLDERS
A
Mall
Approv
Mall
Not Approv
B
Mall
Approv
Mall
Not Approv
Part (a)
Investment
Payoff
Gain/Loss
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8
Mall Exercise: Two Shareholders
Solution: Part a2
ABC’s shareholders’ gain/loss possibilities:
SHAREHOLDERS
A
B
Mall
Approv
Mall
Not Approv
Mall
Approv
Mall
Not Approv
Investment
$200
$200
$800
$800
Payoff
$400
$100
$1,600
$400
Gain/Loss
$200
($100)
$800
($400)
Part (a)
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9
Mall Exercise: Two Shareholders
Solution: Part a3
ABC’s balance sheet possibilities:
Consolidated Balance Sheet
12/30/2009, Pre Payoffs
Mall
approved
Assets
Cash and equivalents
Mall not
approved
1/2/2009
After land
acquired
1/1/2009
After
financing
$2,000
$500
$0
$1,000
$0
$0
$1,000
$0
$2,000
$500
$1,000
$1,000
$0
$0
$0
$0
Common stock
$1,000
$1,000
$1,000
$1,000
Retained earnings
$1,000
($500)
$0
$0
Total stockholders' equity
$2,000
$500
$1,000
$1,000
$2,000
$500
$1,000
$1,000
PP&E
Total assets
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Total liabilities and stockholders' equity
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Mall Exercise: Two Shareholders
Take Away
 The possible downside looks pretty bleak for both
shareholders at the time they invest in ABC.
 They lose a good deal of their investments if the mall is not
approved.
 Without additional information, we can’t conclude how
risky the investment is:
 To quantify the shareholders’ risks, we would need to know
their beliefs about the likelihood that the mall would be
approved when they invested in ABC.
 For example, their perceived risk would be much greater if
they believed there was a 1% chance of approval versus a
95% chance of approval.
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11
Mall Exercise: Two Shareholders
Question
 Compare the risks of Intel’s cash & cash equivalents,
inventories, and property, plant and equipment.
INTEL CORPORATION
CONSOLIDATED BALANCE SHEETS
December 27, 2008 and December 29, 2007
2008
(In Millions--Except Par Value)
Assets
Current assets:
Cash and cash equivalents
$
Short-term investments
Trading assets
Accounts receivable, net of allow ance for doubtful accounts of $17 ($27 in 2007)
Inventories
Deferred tax assets
Other current assets
Total current assets
Property, plant and equipment, net
Marketable equity securities
Other long-term investments
Goodwill
Other long-term assets
Total assets
$
3,350
5,331
3,162
1,712
3,744
1,390
1,182
19,871
17,544
352
2,924
3,932
6,092
50,715
2007
$
$
7,307
5,490
2,566
2,576
3,370
1,186
1,390
23,885
16,918
987
4,398
3,916
5,547
55,651
Intel's 2008 Form 10-K, page 57. www.sec.gov
See accompanying notes in the 10-K.
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12
Mall Exercise: Two Shareholders
Question: Part a4
 Determine ABC’s shareholders’ expected returns at the
time the land is purchased assuming they believe there
is a 50% chance the mall will be approved.
SHAREHOLDERS
A
B
Mall
Approv
Mall
Not Approv
Expected
Mall
Approv
Mall
Not Approv
Expected
Investment
$200
$200
▬
$800
$800
▬
Probability
50%
50%
▬
50%
50%
▬
Payoff
$400
$100
$1,600
$400
Gain/Loss
$200
($100)
$800
($400)
Part (a)
%Return on investment
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13
Mall Exercise: Two Shareholders
Solution: Part a4
ABC’s shareholders’ expected returns:
SHAREHOLDERS
A
B
Mall
Approv
Mall
Not Approv
Expected
Mall
Approv
Mall
Not Approv
Expected
Investment
$200
$200
▬
$800
$800
▬
Probability
50%
50%
▬
50%
50%
▬
Payoff
$400
$100
$250
$1,600
$400
$1,000
Gain/Loss
$200
($100)
$50
$800
($400)
$200
%Return on investment
100%
-50%
25%
100%
-50%
25%
Part (a)
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14
Mall Exercise: Two Shareholders
Take Away
 Without additional information, we can’t determine
whether the 25% expected return is reasonable given the
related risks:
 To this end, the shareholders would need to compare this
investment to expected returns on other investment
opportunities with comparable risk.
 At the time of the purchase, the two shareholders could
have different assessments of the probability that the
mall would be approved, and thus, different assessments
of the payoffs. Additionally, their assessments could
differ from those of ABC’s management.
 As a result, the three parties’ perceptions about the related
risks and the reasonableness of the investment could differ.
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15
Mall Exercise: One Shareholder & One Bank
Things You Need to Know
 On 01/01/2009, ABC Company:
 Issues $200 worth of stock to shareholder A
 Issues $800 worth of debt to First Bank with 10% per year
interest
 On 01/02/2009, ABC purchases land for $1,000
 Next to planned shopping mall
 Mall still needs approval from regulators
 ABC expects to resale the land at the end of 2009:
 For $2,000 if mall approved
 For $500 if mall not approved
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16
Mall Exercise: One Shareholder & One Bank
Things You Need to Know
 On 12/28/2009, ABC learns whether mall is approved
 On 12/30/2009, ABC sells the land
 For $2,000 if mall approved
 For $500 if mall not approved
 On 12/31/2009, ABC distributes its cash to investors
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17
Mall Exercise: One Shareholder & One Bank
Question: Part b1
 Determine ABC’s balance sheet possibilities:
ABC Company Consolidated Balance Sheet
12/30/2009, Pre Payoffs
If Mall
approved
If Mall not
approved
1/2/2009
1/1/2009
After land
purchased
After
financing
Assets
Cash and equivalents
PP&E
Total assets
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
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18
Mall Exercise: One Shareholder & One Bank
Solution: Part b1
ABC’s balance sheet possibilities:
Consolidated Balance Sheet
12/30/2009, Pre Payoffs
Mall
approved
Assets
Cash and equivalents
Mall not
approved
1/2/2009
1/1/2009
After land
acquired
After
financing
$0
$1,000
PP&E
$1,000
$0
Total assets
$1,000
$1,000
$800
$800
$200
$200
$0
$0
$200
$200
$1,000
$1,000
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
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Mall Exercise: One Shareholder & One Bank
Question: Part b2
 Determine ABC’s shareholders’ gain/loss possibilities:
BANKS
SHAREHOLDERS
First
A
B
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
─
─
$200
$200
$800
$800
Payoff
─
─
$400
$100
$1,600
$400
Gain/Loss
─
─
$200
($100)
$800
($400)
$800
$800
$200
$200
─
─
Payoff
─
─
Gain/Loss
─
─
Part (a)
Part (b)
Investment
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Mall Exercise: One Shareholder & One Bank
Solution: Part b2
ABC’s shareholders’ gain/loss possibilities:
BANKS
SHAREHOLDERS
First
A
B
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
─
─
$200
$200
$800
$800
Payoff
─
─
$400
$100
$1,600
$400
Gain/Loss
─
─
$200
($100)
$800
($400)
Investment
$800
$800
$200
$200
─
─
Payoff
$880
$500
$1,120
$0
─
─
Gain/Loss
$80
($300)
$920
($200)
─
─
Part (a)
Part (b)
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21
Mall Exercise: One Shareholder & One Bank
Solution: Part b3
ABC’s balance sheet possibilities:
Consolidated Balance Sheet
12/30/2009, Pre Payoffs
Mall
approved
Assets
Cash and equivalents
Mall not
approved
1/2/2009
1/1/2009
After land
acquired
After
financing
$2,000
$500
$0
$1,000
$0
$0
$1,000
$0
$2,000
$500
$1,000
$1,000
$880
$500
$800
$800
Common stock
$200
$200
$200
$200
Retained earnings
$920
($200)
$0
$0
PP&E
Total assets
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Total stockholders' equity
Total liabilities and stockholders' equity
$1,120
$0
$200
$200
$2,000
$500
$1,000
$1,000
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22
Mall Exercise: One Shareholder & One Bank
Question: Part b4
 What has not changed in part (b) versus part (a)?

What has changed? Why?
BANKS
SHAREHOLDERS
First
A
B
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
─
─
$200
$200
$800
$800
Payoff
─
─
$400
$100
$1,600
$400
Gain/Loss
─
─
$200
($100)
$800
($400)
Investment
$800
$800
$200
$200
─
─
Payoff
$880
$500
$1,120
$0
─
─
Gain/Loss
$80
($300)
$920
($200)
─
─
Part (a)
Part (b)
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23
Mall Exercise: One Shareholder & One Bank
Take Away
 The asset risk is the same—the risk the land value will
decrease.
 Shareholder A is now the sole owner.
 ABC now has financial leverage: Liabilities/assets = 80%.
 Shareholder A has a much larger upside and downside.
 First Bank has a much bigger downside than upside.
 Without knowing First Bank’s assessment of the probability of
the mall’s approval, we can’t determine the bank’s perception
of its risk.
 Similarly, we can’t determine whether this assessment is
reasonable without knowing more about the context.
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24
Mall Exercise: One Shareholder & One Bank
Question: Part b5
 Determine the investors’ expected returns at the time the
land is purchased, assuming they believe there is a 50%
chance the mall will be approved.

Evaluate the bank credit analyst who approved the loan.
BANK
SHAREHOLDER
First
A
Approv
Not Approv
Expected
Approv
Not Approv
Expected
50%
50%
─
50%
50%
─
Investment
$800
$800
─
$200
$200
─
Payoff
$880
$500
$1,120
$0
Gain/Loss
$80
($300)
$920
($200)
Probabilities
Part (b)
% Return on inv
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25
Mall Exercise: One Shareholder & One Bank
Solution: Part b5
 ABC’s investors’ expected returns are reported below.
 The bank’s credit analyst gets a failing grade—the
expected return is negative.
BANK
SHAREHOLDER
First
A
Approv
Not Approv
Expected
Approv
Not Approv
Expected
50%
50%
─
50%
50%
─
Investment
$800
$800
─
$200
$200
─
Payoff
$880
$500
$690
$1,120
$0
$560
Gain/Loss
$80
($300)
($110)
$920
($200)
$360
% Return on inv
10%
-38%
-14%
460%
-100%
180%
Probabilities
Part (b)
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26
Mall Exercise: One Shareholder & One Bank
Question: Part b6
 Determine the probability of approval needed for First
Bank to expect to earn an 8% return on its investment.
Approv
BANK
SHAREHOLDER
First
A
Not Approv
Expected
Approv
Not Approv
─
Probabilities
Expected
─
Part (b)
Investment
$800
$800
Payoff
$880
Gain/Loss
% Return on inv
─
$200
$200
$500
$1,120
$0
$80
($300)
$920
($200)
10%
-38%
460%
-100%
8.0%
─
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27
Mall Exercise: One Shareholder & One Bank
Solution: Part b6
 The probability of approval would need to be 95.83%. This
is the “p” that solves the following:
(10%) * p + (-38%) * (1-p) = 8%
BANK
SHAREHOLDER
First
A
Approv
Not Approv
Expected
Approv
Not Approv
Expected
95.83%
4.17%
─
95.83%
4.17%
─
Investment
$800
$800
─
$200
$200
─
Payoff
$880
$500
$864
$1,120
$0
$1,073
Gain/Loss
$80
($300)
$64
$920
($200)
$873
% Return on inv
10%
-38%
8.0%
460%
-100%
437%
Probabilities
Part (b)
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28
Mall Exercise: One Shareholder & One Bank
Take Away
 Given the 50% approval probability, First Bank could have
done several things to structure the loan better:
 Raise the interest rate considerably
 If the interest rate had been 53.5%, First Bank would have
expected an 8% return on the investment.
 Require Shareholder A to pay a larger portion of the $1,000
investment, which lowers ABC’s financial leverage.
 If the loan had been for $471.7 instead of $800, First Bank would
have expected an 8% return on the investment.
 Bad credit decisions often occur during real estate booms:
 If the land price had recently increased from $500 to $1,000
because of risk seekers betting on mall approval or there was
a real estate bubble, banks might have underestimated losses.
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Return to menu
Mall Exercise: One Shareholder & Two Banks
Things You Need to Know
 On 01/01/2009, ABC Company
 Issues $200 worth of stock to shareholder A
 Issues $800 worth of debt to First Bank with 10% per year
interest
 Issues $1,000 worth of subordinate debt to Second Bank, with
a 15% rate
 On 01/02/2009, ABC purchases two parcels land for $2,000
 Next to planned shopping mall
 Mall still needs approval from regulators
 ABC expects to resale the land at the end of 2009:
 For $4,000 if mall approved
 For $1,000 if mall not approved
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Mall Exercise: One Shareholder & Two Banks
Things You Need to Know
 On 12/28/2009, ABC learns whether mall is approved
 On 12/30/2009, ABC sells the land
 For $4,000 if mall approved
 For $1,000 if mall not approved
 On 12/31/2009, ABC distributes its cash to investors
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31
Mall Exercise: One Shareholder & Two Banks
Question: Part c1
 Determine ABC’s balance sheet possibilities:
ABC Company Consolidated Balance Sheet
12/30/2009, Pre Payoffs
If Mall
approved
If Mall not
approved
1/2/2009
1/1/2009
After land
purchased
After
financing
Assets
Cash and equivalents
PP&E
Total assets
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
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32
Mall Exercise: One Shareholder & Two Banks
Solution: Part c1
 Determine ABC’s balance sheet possibilities:
ABC Company Consolidated Balance Sheet
12/30/2009, Pre Payoffs
If Mall
approved
If Mall not
approved
1/2/2009
1/1/2009
After land
purchased
After
financing
Assets
Cash and equivalents
$0
$2,000
PP&E
$2,000
$0
Total assets
$2,000
$2,000
$1,800
$1,800
$200
$200
$0
$0
$200
$200
$2,000
$2,000
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
33
Return to menu
Mall Exercise: One Shareholder & Two Banks
Question: Part c2
 Determine ABC’s shareholders’ gain/loss possibilities:
BANKS
SHAREHOLDER
First
Second
A
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
$800
$800
─
─
$200
$200
Payoff
$880
$500
─
─
$1,120
$0
Gain/Loss
$80
($300)
─
─
$920
($200)
Part (b)
Part (c)
Investment
Payoff
Gain/Loss
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Mall Exercise: One Shareholder & Two Banks
Solution: Part c2
ABC’s shareholders’ gain/loss possibilities:
BANKS
SHAREHOLDER
First
Second
A
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
$800
$800
─
─
$200
$200
Payoff
$880
$500
─
─
$1,120
$0
Gain/Loss
$80
($300)
─
─
$920
($200)
Investment
$800
$800
$1,000
$1,000
$200
$200
Payoff
$880
$880
$1,150
$120
$1,970
$0
Gain/Loss
$80
$80
$150
($880)
$1,770
($200)
Part (b)
Part (c)
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35
Mall Exercise: One Shareholder & Two Banks
Solution: Part c3
 Determine ABC’s balance sheet possibilities:
ABC Company Consolidated Balance Sheet
12/30/2009, Pre Payoffs
If Mall
approved
If Mall not
approved
1/2/2009
1/1/2009
After land
purchased
After
financing
Assets
Cash and equivalents
PP&E
Total assets
$4,000
$1,000
$0
$2,000
$0
$0
$2,000
$0
$4,000
$1,000
$2,000
$2,000
$2,030
$1,000
$1,800
$1,800
$200
$200
$200
$200
$0
$0
Liabilities and stockholders' equity
Debt
Stockholders' equity:
Common stock
Retained earnings
$1,770
Total stockholders' equity
$1,970
$0
$200
$200
$4,000
$1,000
$2,000
$2,000
Total liabilities and stockholders' equity
($200)
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Mall Exercise: One Shareholder & Two Banks
Question: Part c4
 What has not changed in part (c)?

What has changed? Why?
BANKS
SHAREHOLDERS
First
Second
A
Approv
Not Approv
Approv
Not Approv
Approv
Not Approv
Investment
$800
$800
─
─
$200
$200
Payoff
$880
$500
─
─
$1,120
$0
Gain/Loss
$80
($300)
─
─
$920
($200)
Investment
$800
$800
$1,000
$1,000
$200
$200
Payoff
$880
$880
$1,150
$120
$1,970
$0
Gain/Loss
$80
$80
$150
($880)
$1,770
($200)
Part (b)
Part (c)
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37
Mall Exercise: One Shareholder & Two Banks
Take Away
 Shareholder A has the same downside but a bigger upside.
 First Bank has no risk because Second Bank has effectively
provided a safety cushion through subordination.
 Second Bank’s credit analyst has made so many blunders;
First Bank’s credit analyst has managed to escape a really
bad deal.
 When companies have nothing else to lose, they have a
strong incentive to gamble with other people’s money.
 Risk and reward go together when everyone behaves
rationally.
 Second Bank was not acting rationally, and as a result,
Shareholder A’s and First Bank’s rewards increased, but not
their risks.
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38
Closing Thoughts
 The concepts and lessons discussed here were center
stage in the 2007-2009 credit crisis:
 Real estate prices increased dramatically in many areas of
the world during 2005-2007.
 Credit controls were very weak:
 No down payments were required.
 Customers without safety nets could barely make payments in
good times.
 Banks sold loans for a profit shortly after they were initiated,
and thus, they had no incentive to control credit risks.
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39
Closing Thoughts

Owners of Bear Stearns’ common stock realized the
risks associated with financial leverage in March, 2008
when the value of their shares fell to $2 per share, after
being worth more than $90 two months earlier.
 Measured as liabilities divided by assets, Bear Stearns’
financial leverage was 97% on November 30, 2007 (the end
of the fiscal year prior to the company’s downfall) and a
good deal of its assets were very susceptible to risks
associated with mortgages.
 Towards the end of 2007 it became apparent that the risks
associated with mortgages and related securities were
considerably higher than most investors expected.
 The compounding effect of Bear Stearns’ high financial
leverage and high asset risk amplified the owners’ risk
tremendously.
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