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Corporate Finance
University of Kansas School of Law
Harper Ho, Virginia

Corporate Finance

Professor Virginia Harper Ho

Spring 2011

I. OVERVIEW

Introduction to Corporate Finance

· Financial Decisions: sale of financial assets to raise money

o Financial assets: securities, stocks, bonds

· Investment Decisions: purchase of real assets (that you hope will earn value)

o Real assets: PPE, patents, etc.

o Capital budgeting or Capital expenditures

o OR could reserve cash or pay dividends

· Your client

o CFO

o Controller- in charge of tax, auditing, accounting functions

o Treasurer- in charge of cash management

· Regulators

o Securities regulation

§ Federal corporate law

§ Investment intermediaries

§ Accounting Rules

o Accounting

§ PCAOB- auditing function

o State Corporate Law (DE for KS, MBCA for MO)

· Intro to Accounting

o GAAP (US) and IFRS (rest of world)

§ Principles and standards, not exact rules

§ There is an effort to move GAAP closer to IFRS standards

o In Re Bowles footnote- hierarchy for GAAP (SEC and FASB)

· Financial Statements

o Balance Sheet

o Income Statement

o Statement of Cash Flows

o Statements of Shareholders’ Equity

· Basic Accounting Principles

o Historical cost principle- assets on B/S are reported at the cost where they are bought

o Reliability principle- numbers need to be accurate

o Economic entity principle- reports will cover an entire economic entity

§ No limits for international affiliates

§ Parent companies that own over 50% of affiliate

o Matching income and expenses in accounting period (accrual)- as soon as obligation is incurred, it is a cost, and income and expenses must be matched

o Transparency of methods- must show what methods are used (judgment calls)

o Consistency of methods- from year to year

o Going concern assumption- must assume the business is ongoing (even if business is tanking)

o Conservation principle- always take the approach that will result in lower profits for the organization

o Monetary principle- all transactions in the same currency

· Quick check problem 2.1 (page 9)

o Client bought dog for 100k, paid for with two 50k cats

o These are decided by book values

Financial Statements

· Balance Sheet

o Cash accounting

§ Record revenue when received

§ Record expenses when actually paid

o Accrual accounting

§ Record revenue when earned (delivery) – if received later, A/C

§ Record expenses when incur obligation to pay – if paid later, A/P

o Handout 1- balance sheet exercise

o Not on the balance sheet

§ Contingent liabilities

§ Operating leases (unlike buying the equipment)

§ Other transactions like: JVs, R&D partnerships

§ Value of company’s reputation, employee know-how, productivity potential

o Basic “Balance Sheet Equation”

§ Assets = Liabilities PLUS Owners’ Equity

o Valuation numbers shown for assets on the balance sheet reflect book value

§ Book value = the historical price at which asset was acquired

o Firm’s net worth is represented on the balance sheet by:

§ Shareholder Equity = Assets – Liabilities

· Income Statement

o Purpose:

§ Match the expenses for producing revenue with said revenue in the period that the expenses are incurred

· This is accrual accounting

o Parts of Income Statement

§ Sales (Revenue)

· Always at top line and reports all revenue for the period (example: all of 2001)

§ Costs and Expenses

· Cost of sales

o How do we determine cost of sales when cost of inventory is different for different widgets from year to year

§ This is where LIFO and FIFO come in

· Gross margin on sales

o = Sales – COS / Sales = %

· Inventory Accounting / Calculating COGS

o LIFO / FIFO

§ FIFO

· Use cost of the oldest unit in inventory (First In, First Out)

o Minority position used particularly by tech industry to reflect how goods in that industry move quickly

o Better value of inventory because what is left is most recently acquired inventory

§ LIFO

· Use cost of the newest unit in inventory (Last In, Last Out)

o Results in lower profits usually

o If cost is going up then profit and taxes will go down (can function like a tax shelter

§ Weighted average cost = (unit cost A * % of units at cost A) + (unit cost B * % of units at cost B)

§ Stock Compensation

· Cost of giving stock options to employees

o Basic Formula of Income Statement

§ Revenues – Expenses = Net Income

· Net income is the magic number that people talk about, when companies release their “earnings”

o Different Ways to Look at Earnings

§ Net Earnings: Earnings after interest and taxes are taken out (i.e. the “Bottom Line” earnings numbers companies announce)

§ EBIT (“Earnings Before Interest & Taxes”) = Operating Profit

§ Earnings Per Share = Net Earnings / # of shares

· Basic vs. Diluted EPS

o Diluted means company has issued rights to convert into common shares (i.e. like a convertible preferred stock) and it takes it into account

o Obligations that directors and officers have with regard to financial statements\

§ In re Software Toolworks, Inc. (9th Cir. 1994) – P. 30

· Claims:

o Toolworks falsely fabricated 1990 income by reporting as revenue sales to original equipment manufacturer (“OEMs”) (Hyosung) with whom Toolworks has no binding agreement

o Toolworks fabricated large consignment sales in order to meet first quarter 1991 financial projections

§ Did it to make their revenue look much better and shouldn’t have because they weren’t real sales they were consignment sales and shouldn’t be booked until they were actually sold

o Toolworks lied to SEC in response to questions before the registration statement became effective

· Other issues:

o Secondary offering is a public offering after your IPO

o Underwriter is a middleman, they buy into the offering and resell to the public

o Consignment sale contract key point is that seller is not allowed to book the revenue into the goods are actually sold. The goods are given to a third party on consignment to sell on behalf of the manufacturer.

· Statutory Law Involved

o Securities Act of 1933, §11

§ Underwriters can be on the hook because they signed the registration statement (as is any other person who signed the registration statement)

§ These people are liable to anyone who acquires a security with an untrue statement of material fact

· Can get off the hook if you meet the requirements of some of the defenses

o Reasonable investigation

§ Normally allowed to rely on accountant if it is reasonable to rely on them

§ Or other types of experts

o Securities Act of 1933, §12

· Statement of Shareholder Equity

o General Information

§ How things have changed from last reporting period to present

§ Net earnings reappears here

§ Will show issuance of dividends here as well

§ Shows ending period balance

o Way it works

§ Net Income this year

· LESS dividends paid

· PLUS funds raised by new share sales

· LESS funds expended on stock repurchases (like dividends, but not pro rata)

· Summary of Financial Statements

· Financial Statement Ways to Look at How Company is Doing

· Balance Sheet

o Net worth

§ Equals book value = stockholders equity

· Income Statement

o Net earnings

§ EPS, EBIT

· Stmt of Cash Flows

o EBITDA

o Free cash flow

§ Looking at EBITDA and deducting equipment related purchases (will talk about more tomorrow)

· Financial Statement Judgment Calls

§ Inventory Accounting

· Choice of LIFO or FIFO

o Important because cost changes over time

o Which method used decides what COGS is

§ Profit Margin = Sales MINUS COGS

o (SEE “INCOME STATEMENT” ABOVE)

§ Different Depreciation Methods

· Straight Line v. Accelerated

o (SEE “STATEMENT OF CASH FLOWS” ABOVE)

§ Expense v. Capitalization

· Worldcom

o Accounting decision to capitalize “line costs” was found to be criminal

§ Line costs were Worldcom’s single biggest operating expense. Line cost’s were cost of leasing other network operator’s lines to transmit Worldcom’s data and voice traffic.

§ Worldcom capitalized these costs over time instead of expensing them against current income

§ The result?

· If it is expensed we see it right as the expense occurred so the expense should show up in the period it occurred giving us a more accurate picture of what is happening on their financials. But instead they capitalized it so the only thing that showed on financials was the depreciation in each period of the capitalizing period they used. Misleading everyone and making company look much more profitable.

· Capitalizing Slide from class 5>

o Depreciating cost of shirt (30) by putting on balance sheet instead of placing all of the $30 cost on the income statement (like you would if it were expensed). So for the first year only half of the shirt is on income statement (as depreciation) and the second half of shirt is depreciated on second year’s income statement and the balance sheet shows the shirt asset is fully depreciated.

§ Timing of revenues and expenses

§ One-time (non-recurring) items

§ Management Control over Operating Costs

§ Valuation of “Intangibles”

· Things like IP can be fuzzy on how you value them and can make an impact on the financials