ACCT 2102 Lecture 3 Lecture 4 Review (9/9)I. Cash FlowsII. Depreciation III. After-Tax Cash FlowsLecture 5 (9/11)I. Debt Financing A. Definition of LiabilitiesB. Types of LiabilitiesC. Rate of ReturnD. Interest and Taxes II. Risk of Debt FinancingA. Financial RiskB. MeasuresC. Times Interest EarnedIII. Reward of Debt FinancingA. Financial LeverageB. MeasuresIV. Equity FinancingA. Owner’s EquityB. Debt versus Equity FinancingV. Return of EquityA. DefinitionB. CalculationVI. Financial RatioA. Debt to EquityVII. Types of Business CombinationsA. Advantages & Disadvantages of Sole Proprietorships and PartnershipsB. Advantages & Disadvantages of CorporationsVIII. Determining the Allocation of Profits/Losses in PartnershipCurrent Lecture These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.Purpose of Financingo Business need to acquire new assets; financing helps fund these assetsAssets = Liabilities + Owner’s Equityo There is debt financing and equity financingDebt Financingo Debt financing uses a company’s liabilities, which are a debt of the companyo Liabilities can be short-term or long-termo Liabilities can also be formal or informalFormal liabilities: borrowings from third parties (notes and bonds payable)Informal liabilities: arise through the normal course of business (accounts payable; wages payable)o In Ch. 12, we discussed Rate of Return, the rate the makes creditors feel that loaning is worthwhile.o The interest rate associated with that return is associated with debt.o When interest paid on debt is an expense, it reduces net income and is deductible for tax purposes.o Taxes decrease whenever interest expense is deducted on the tax return. The company’scost of carrying the debt and the rate actually paid on the debt are then reduced also. Risks of Debt FinancingThere are risks to debt financing. There is always the possibility that a company, as debt obligations become due, won’t be able to meet them.o Measuring Risks:- Debt to Equity Ratio (Total Debt/ Total Equity)- Times Interest Earned Ratio (NI before I & T/ Interest Expense) - measures relationship of income before interest and taxes to interest expenseEx: Watson, Inc. expects to earn income before interest and taxes of $600,000 during the year. Ifits interest expense is $50,000, what is Watson’s times interest earned ratio?$600,000/ $50,000 = 12*You want to have a higher number such as 12. This number means that the company would be able to pay their interest 12 times during that year, meaning sufficient income is coming in.Reward of Debt Financing o Financial Leverage: With debt financing, a company has the ability to possibly earn areturn that is greater than what it cost to borrow in the beginning.o When this happens, it is a positive effect of financial leverage for shareholders.Measuring Financial Leverage: Return on Equity (measures net income to total owner’s equity)Equity Financing o Companies also can use Owner’s Equity as a way to finance. o Owner’s Equity is achieved two ways:1. through issuing stock to shareholders, and2. by the company itself though retained earningso Equity financing is different from debt financing. In debt financing, interest is deductible.However, in equity financing, dividends are not deductible. Ex: A company with net income of $50,000 distributes $10,000 to its shareholders. Since no tax savings are derived from paying dividends, the cost of paying the dividend is $10,000 and retained earnings is reduced by the $10,000.o To measure a company’s performance, the Return on Equity ratio is used.ROE = After-Tax NI ÷ Owners' EquityStrate Company has OE of $500,000 and no debt. It expects $100,000 of NI before taxes; its tax rate is 25%.Step 1: $100,000 (BEFORE taxes; we need after tax) * .25 = 25,000 Income taxStep 2: $100,000 -- $25,000 = $75,000 After-tax incomeStep 3: After-Tax NI + Owners' Equity $75,000/ $500,000 = 15%o With equity financing, as company, relying solely on causes companies lose out on the financial leverage you can gain from Return on Equity from debt financing.o The upside to equity financing is that shareholders are exposed to the risks of a companydefaulting on debts.- The increase of debt in a company, increases these risks.Debt to Equity ratio: measures a company’s debts in relation to its equity, measuring the company’s leverage.- The more debt a company has, the higher the debt to equity.Types of Business Combinationso Sole Proprietorshipo Partnershipo CorporationAdvantages & Disadvantages of Sole Proprietorships and Partnershipso Advantages:- Ease of formation- Income taxes only at the individual’s level- More owner involvemento Disadvantages:- Unlimited liability- Limited ability to raise capital- Mutual agency (partnerships)Advantages & Disadvantages of Corporations o Advantages: - Limited liability- Unlimited life- Ability to raise capitalo Disadvantages:- Regulatory requirements- Double taxationDetermining Allocation of Profits & Losses in a Partnershipo Fixed ratio: each partner receives specific percentageo Ratio of capital balances: percentages are based on capital put in by each partnero Salary allowanceso Interest allowanceso CombinationFixed Ratio:John, Doe and Smitty are partners in the NoName Company. Their profit and loss sharingrelationship is 7:5:3. Doe's share of a $75,000 partnership loss would be: Step 1: 7+5+3 = 15Step 2: Doe = 5 5/15 = 33.3% (Doe’s percentage)Step 3: $75,000 * 33.3% (.333) = $24,975 (round up to $25,000)Ratio of Capital Balances:Ned, Otis, and Eon, who are partners in the Josephine Company, had beginning capital balances of $35,000, $62,000, and $28,000, respectively. If the partners share income and losses based on the ratio of their beginning capital balances, Otis's share of a $250,000 partnership loss would be: Step 1: $35,000 + $62,000 + $28,000 = $125,000Step 2: Otis ($62,000) $62,000/ $125,000 = .496 (49.6%)Step 3: $250, 000 * .496 =