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Lecture 1

COMMERCE 1AA3 Lecture Notes - Lecture 1: Leveraged Buyout, New Profit Inc., Capital Structure

Course Code
Emad Mohammad

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COMMERCE 1A03 November 14, 2018
Chapter 8
Liabilities make business look risker. Risker businesses cannot obtain loans on favourable terms.
Risker businesses receive lower market valuations (i.e. stock prices), all else equal.
You can borrow as long as you invest in projects that yield a return that is higher than the
interest rate on your debt.
Financing the Business
Businesses finance the acquisition of assets by:
Equity (financing by owners)
The mix of debt and equity is called the capital structure
Debt financing is cheaper but riskier than equity because interest payments are legal
obligations and creditors can force bankruptcy
Why Take the Risk of Debt Financing?
Debt financing has the advantage of financial leverage
Owners can potentially increase the return on their investments when they
finance new projects with debt
Wealth transfer: transactions that create value to shareholders at the expense of
creditors (e.g., leveraged buyouts, or LBO)
Financial Leverage Illustrated
As of 1/1/2017, ABC Inc., had total assets of $1 million, and total shareholders’ equity of $1M.
As of that day, ABC has an investment opportunity that costs $100,000 and will generate annual
return of 15%. ABC does not have enough cash to make the investment, thus they have to
either raise capital or borrow at 12% interest rate. Assume that ABC can secure the financing
and start the investment on 1/1/2017. Net income for 2008without the project is $300,000.
Financial Leverage
Return from new project = 100,000 x 15% = $15,000
Profit after the new project = 300,000 + 15,000 Interest
Return on Equity = New Profit / SE

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COMMERCE 1A03 November 14, 2018
Chapter 8
Definition and Characteristics
Three essential characteristics of a liability
A present obligation that entails settlement by probable future transfer or use
of cash, goods, or services
There is little or no discretion to avoid the obligation
Obligation arises from a transaction or event which has already occurred (i.e.,
past transactions)
Current Liabilities
Expected to be paid:
From existing current assets or through the creation of other current liabilities
Within one year or operating cycle, whichever is longer
Debts that do not meet both criteria are classified as long-term liabilities
Therefore, short-term debt expected to be refinanced WILL NOT BE CLASSIFIED AS A
Obligations due within one year
Two types:
Known amounts (e.g., A/P, N/P, and salaries payable)
Estimated amounts (e.g., contingent liabilities and warranties)

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COMMERCE 1A03 November 14, 2018
Chapter 8
Types of current liabilities include:
Accounts Payable- Trade A/P
Notes Payable- Due within one year
Current Portion of Long-Term Debt
Unearned Revenues
Sales Taxes Payable
Goods and Services Tax Payable
Property Taxes Payable
Income Taxes Payable
Employee-related Liabilities
Estimated Liabilities Reported on the Balance Sheet
Contingent Liabilities and Commitments
Accounts Payable
Amounts owed for goods, supplies or services purchased on open account
Liability recorded when title has passed
Recorded at amount payable
Notes Payable
Notes payable are written promises to pay a sum of money on a specified future date
Arises from purchases, financing or other transactions
Notes payable may be classified as either short-term or long-term
Notes payable may be interest-bearing or zero-interest-bearing (non-interest-bearing)
In both cases, interest expense is determined whenever financial statements are
Interest-Bearing Notes
The interest rate is stated explicitly on the note.
For long-term notes, payments can be for:
Interest only,
fixed principal plus interest on the remaining balance, or
Equal payments consisting of interest and principal
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