Accelerating Earnings for Financial Reporting Purposes Generally accepted accounting principles permit a corporation to use a
Accelerating Earnings for Financial Reporting Purposes Generally accepted accounting principles permit a corporation to use a
portfolio of its receivables or assets to accelerate earnings for share- holder reporting. This reason is best described by means of an illustra- tion.
Consider again Farm Equip Corporation, the manufacturer of farm equipment. Suppose that this firm has $200 million in installment sales contracts. For financial reporting purposes, the installment sales con- tracts are not realized as revenue until the installment payments are received. Suppose that the agreement with the buyer of the farm equip- ment requires that the buyer pay 8% interest per annum. Suppose fur- ther that the treasurer of Farm Equip Corporation approaches the firm’s investment banker and is told that it can sell an asset-backed security backed by the installment sales contracts at a cost of 5%. This means that Farm Equip Corporation is receiving from the installment sales contracts 8% and would pay investors in the asset-backed securities 5%. The difference between what Farm Equip Corporation is receiving and paying is 3% or 300 basis points. Part of that difference represents
a cost to Farm Equip Corporation for “servicing” the installment sales contracts. For now, assume that the servicing fee is 1%. Reducing the 300 basis points by the 100 basis point servicing fee, means that there are 200 basis points remaining. This is referred to as the net interest spread. This is a profit to Farm Equip Corporation that will be realized by the sale of the asset-backed securities and it can be booked as income immediately. The income is effectively in the form of an asset referred to as interest-only strip. How much is the income that will be realized by Farm Equip Corporation for financial reporting pur- poses? Or equivalently, what is the value of the interest-only strip? We can apply the basic principle of valuation to determine it. This is done as follows. First, Farm Equip Corporation’s treasurer must determine the dollar amount of the 200 basis points for each year over the expected life of the asset-backed security. Then the present value of this dollar amount for each period is computed.
For example, suppose that the $200 million in installment sales con- tracts call for a repayment of principal of $50 million per year for the next four years. Then assuming that none of the borrowers default on their contractual obligation or pay off their loans earlier than the sched- uled principal repayment date (referred to as a “prepayment”), this means that each year the dollar net interest based on the net interest spread of 200 basis points is as follows:
Borrowing Via Structured Finance Transactions
Beg. of Year Balance Outstanding Dollar Net Interest
The next step is to compute the present value of the dollar net inter- est. The question is: What is the appropriate discount rate? The dis- count rate should reflect the uncertainty of realizing the projected dollar net interest over the next four years. Let’s suppose that a fair market rate is 12%. Then the present value of the dollar net interest 12% is $8,022,088.78 as shown below: 2
Beg. of Balance
PV Factor at Present Year
Dollar Net
635,518.08 Value of interest-only strip $8,022,088.78
The $8,022,088.78 would be reported as income in the year that the asset- backed securities are issued and is the value of the interest-only strip.
The key in the valuation of the interest-only strip is determining the dollar net interest spread each year and the appropriate interest rate at which to discount the dollar amount for each year. Consider first the dol- lar net interest each year. In the analysis above, it is assumed that the $200 million in installment sales contracts will be paid—that is, no defaults are assumed. Suppose instead that, due to defaults, the treasurer projects that the balance outstanding after defaults is as follows:
Beg. of Year Balance Outstanding Dollar Net Interest
2 Notice that calculations have been simplified by assuming that all of the dollar net interest spread is received at the end of the year.
SELECTED TOPICS IN FINANCIAL MANAGEMENT
Then the dollar net interest and the present value at 12% each year are shown below, along with the value of the interest-only strip:
Beg. of Balance
Present Year
Dollar Net
PV Factor
533,835.19 Value of interest-only strip $7,783,539.09
Thus, based on this, the reported income due to the securitization would be $7,783,539.09 (the value of the interest-only strip) versus $8,022,088.78, in the case where no defaults are assumed. If a more appropriate dis- count rate is higher than 12%, then the value of the interest-only strip is reduced. For example, at a 15% rate, the value of the interest-only strip is $7,633,477.58, assuming no defaults and $7,413,485.51, assuming the defaults in the table above.
If there are prepayments, this reduces the value of the interest-only strip. This is because when a borrower repays a loan, this reduces the loan balance. The issuer receives the dollar net interest only on the out- standing loan balance. For example, suppose that there are no defaults but that the borrowers prepay their loans such that the balance out- standing each year is as follows:
Beg. of Balance
Dollar Net
Year Outstanding
It can be shown that the present value of the interest-only strip in this case is $5,099,315.71. When discounted at a 12% rate, the value is less than even the case above, where there are defaults.
It is not a simple task to determine the defaults and therefore the dollar net interest and the appropriate interest rate for discounting. Consequently, the firm’s external auditors must assess the assumptions made by management in determining income resulting from a securitiza- tion. There are shareholder suits against management and its external auditors in cases where shareholders have challenged income generated
Borrowing Via Structured Finance Transactions
from a securitization for a firm that has faced financial difficulties. The issue is whether reasonable assumptions were made regarding defaults and whether the appropriate discount rate was used.
It is important to understand that a corporation can use a struc- tured financing to achieve a target income. Stock analysts project a con- sensus earnings for a corporation. Suppose that management in the absence of securitization needs $0.10 per share to achieve the target earnings. Management can use all or part of its receivables or loans to achieve the targeted amount via securitization.
One more advantage should be noted. Our discussion here deals with realization of income for financial reporting purposes. How about the tax treatment? Under the tax code, the sale of the assets to the SPV and the resulting income need not be recognized for this purpose. That is, income realized for financial reporting purposes need not be realized for tax purposes. So, income can be accelerated for financial reporting purposes by selling financial assets but taxes on that income can be postponed for tax purposes.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more