Off Balance Sheet Financing & Corporate Life Cycle

JWI 531 Financial Management II, week5 summary, 5/12/13

I have gained a much better appreciation for basing a lease vs buy decision on sound financial fundamentals that apply to the context of the firm. There are no set answers and one must decide based on the changing marketplace realities.

Understanding different types of leases and becoming aware of off-balance-sheet financing practices (W5, L1), I can now - for the first time - begin to see through the Enrons of the world.

The corporate life cycle (W5,L2), beginning with an idea and a strong champion shows me how businesses evolve. I can see how the financial needs of the firm change and what sources of funds are best suited for the various stages of the life cycle. I can see this course neatly leading up to the New Business Ventures course and preparing me with financial wings to take off and fly.

Solid week. Enjoyed it much. Takeaways below.
Dr DP

JWI 531 Financial Management II, week5 summary, 5/12/13
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I. Week5 Lecture1
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Debt is a measure of assets & risks

Off-balance-sheet (OBS) financing are debt obligations that do not appear on the balance sheet
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Some companies misuse OBS financing to hide problems and make balance sheet look better than it actually is
the company's debt can be assigned to an off-balance sheet entity to improve financial ratios
value of operating leases can be much more than stated debt figures
noncancelable leases = debt and appear in 10Ks
Study OBS financing carfully to understand commitments, value a company, before deciding to invest

OBS financing can be
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- leases
- sale of receivables
- limited partnerships
- Joint Ventures

Four Legitimate uses of OBS (financialweb)
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(i) Pursue similar business opportunity
(ii) Explore new business
(iii) operating lease for expensive equipment
(iv) building leases

Presentation of lease obligations under balance sheets instead of 10K 10Q foot notes make it more transparent

A lease refers to an arrangement by which you use an item that belongs to another party for a certain period of time and pay a fee for the privilege.  A capital lease, also known as a finance lease, runs for most of the useful life of the asset and has various advantages and disadvantages.

Two kinds of Leases: Operating & Capital
(i) Operating lease   
Pros - Rent an asset; Only rental payments, no asset sale,  heavy debt; use asset without handicapping balance sheet,leverage ratios or cash flow eg. retailers in a mall. Accounted for by cash outflow from operations

(ii) Capital lease   
Cons - Treated as a sale; Ownership rights transferred to lessee; Risks of ownership transferred to the balance sheet
Accounted for by split up into operating activities & financing activities       

Formula
Value of Noncancelable Operating Leases * 8 = Debt Equivalent of Operating Leases
Add this to debt amount to understand financial leverage

From the standpoint of a business owner, what is the relative appeal of lease arrangements?
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Leasing conserves Cash upfront
Cash-starved firms often have to decide between buying or leasing equipment or properties. Buying can give long term ownership and total control of resources but will also tie up capital early on and could restrict choices - due to loss of liquidity - for a business subsequently.
A lease refers to a more flexible financial arrangement by which one can use an item that belongs to another party for a certain period of time and pay a fee for the privilege (ehow.com). There are two kinds of leases: operating & capital (JWI 531, W5 L1).
Operating Lease
In this case only rental payments are made by the lessee to the lessor. This is accounted for as an expense - cash outflow from operations - and the balance sheet is not impacted. Maximum flexibility is enjoyed by the lessee as she can focus on running her business and walk away from the arrangement practically any time to react quickly to changing market place and business needs - particularly in a fast paced or highly competitive business.
Example: PC retailers renting spaces in a mall may need all the resources they can muster to survive and adapt in a new era where smartphones and tablets have invaded.
Capital lease
This arrangement is treated as a sale with ownership rights and risks of ownership transferred to the lessee. Capital leased properties are accounted for as an asset as well as a liability in the balance sheet. Therefore the lessee's net worth is unchanged but the presence of the added liability leads to a degrade in Debt/Equity ratio that may be frowned upon by investors. However, the lessee may be able to use the asset for up to 75% of the asset's life and may also be able to buy the asset at a price discounted from the market price. Also, tax deduction can be claimed on (a) the cost of the capital lease as a depreciation - a deduction each year over the life of the asset  and (b) interest paid on the lease each year (smallbusinesschron.com).

References
http://www.ehow.com/info_12092374_advantages-disadvantages-capital-lease.html
http://yourbusiness.azcentral.com/advantages-disadvantages-capitalizing-lease-eyes-lessee-5505.html
http://www.finweb.com/investing/4-legitimate-uses-of-off-balance-sheet-financing.html#axzz2Slhn1rf0
http://people.stern.nyu.edu/adamodar/New_Home_Page/AccPrimer/lease.htm
Brigham & Ehrhardt (2009), Financial Management
http://smallbusiness.chron.com/tax-benefits-operating-vs-capital-lease-21643.html


II. Week5, Lecture2
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The corporate lifecycle
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Embryo -Early days of a company: All you have is an idea; ntrepreneur with skin in the game - credit card & savings
Birth- A strong champion willing to nurture that idea marks the birth of a business - Friends & family loans & small business loans
Adolescence-Depends on strengths of business; Angels ($100K-$1M)& VC investors ($500K-$10sM) - Profitable, growing, good cash flow
Adulthood - Strategy; Grow fast and achieve great scale
Win-Reward customers, employees, owners through each step of the process
End-Bankruptcy; M&A

Business Plan & a Dream
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Venture Capital: A form of private equity investing
Typically fun firms within 1-3 yrs of existence
Choicest ideas with the largest probability of success, market opportunity, potential payoff.
Industries with high pay off: technology, pharmaceuticals, biotech, media and communicaitons
Require capital in millions of dollars & poised for extreme growth
Extraordinarily high risk investments that most banks will balk at.
Portfolio approach - Few wins, 70%-80% fail
VC funds: pool money from high net worth individuals, institutions and spread the risk across opportunities