11 Making Informed Judgments Part 5 Risks and Rewards Application: Shopping Mall Exercise and Credit Crisis Navigating Accounting, ® G. Peter & Carolyn R. Wilson, © NavAcc LLC. Modified by [Your Name].

22Menu  Shopping Mall Exercise:  Two shareholders Two shareholders  One shareholder and one bank loan One shareholder and one bank loan  One shareholder and two bank loans One shareholder and two bank loans  Closing thoughts Closing thoughts View in Slide Show Mode > click hyperlink.

33 Mall Exercise: Two Shareholders  On 01/01/2009, ABC Company is formed and issues stock to two shareholders  $200 worth of stock to shareholder A (20%)  $800 worth of stock to shareholder B (80%)  On 01/02/2009, ABC purchases land for $1,000  Land is next to a planned shopping mall  Mall still needs approval from regulators  ABC expects to resale the land at the end of 2009:  For $2,000 if the shopping mall is approved by regulators  For $500 if the shopping mall is not approved Things You Need to Know Return to menu

44 Mall Exercise: Two Shareholders  On 12/28/2009, ABC learns whether the mall is approved or not  On 12/30/2009, ABC sells the land  For $2,000 if the mall is approved  For $500 if the mall is not approved  On 12/31/2009, ABC distributes the cash from the sale of the land to its shareholders. The payoffs are in proportion to the shareholder’s equity stake in the company.  ABC is located in a country where there are no taxes. Things You Need to Know Return to menu

55 Mall Exercise: Two Shareholders  Determine ABC’s balance sheet possibilities: Question: Part a1 Return to menu

66 Mall Exercise: Two Shareholders ABC’s balance sheet possibilities: Solution: Part a1 Consolidated Balance Sheet 1/2/20091/1/2009 Mall approved Mall not approved After land acquired After financing Assets Cash and equivalents PP&E Total assets Liabilities and stockholders' equity Debt Stockholders' equity: Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity 12/30/2009, Pre Payoffs $0$1,000 $0 $1,000 $0 $1,000 $0 $1,000 Return to menu

77 Mall Exercise: Two Shareholders  How did the land purchase affect the balance sheet?  Why would an investor want to know about this change? Question Return to menu

88 Mall Exercise: Two Shareholders  Determine ABC’s shareholders’ gain/loss possibilities: Question: Part a2 Return to menu

99 Mall Exercise: Two Shareholders ABC’s shareholders’ gain/loss possibilities: Solution: Part a2 Mall Approv Mall Not Approv Mall Approv Mall Not Approv Part (a) Investment$200 $800 Payoff$400$100$1,600$400 Gain/Loss$200($100)$800($400) SHAREHOLDERS AB Return to menu

10 Mall Exercise: Two Shareholders ABC’s balance sheet possibilities: Solution: Part a3 Consolidated Balance Sheet 1/2/20091/1/2009 Mall approved Mall not approved After land acquired After financing Assets Cash and equivalents PP&E Total assets Liabilities and stockholders' equity Debt Stockholders' equity: Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity 12/30/2009, Pre Payoffs $2,000$500$0$1,000 $0 $1,000$0 $2,000$500$1,000 $0 $1,000 ($500)$0 $2,000$500$1,000 $2,000$500$1,000 Return to menu

11 Mall Exercise: Two Shareholders  The possible downside looks pretty bleak for both shareholders at the time they invest in ABC.  They lose a good deal of their investments if the mall is not approved.  Without additional information, we can’t conclude how risky the investment is:  To quantify the shareholders’ risks, we would need to know their beliefs about the likelihood that the mall would be approved when they invested in ABC.  For example, their perceived risk would be much greater if they believed there was a 1% chance of approval versus a 95% chance of approval. Take Away Return to menu

12 Mall Exercise: Two Shareholders Return to menu  Compare the risks of Intel’s cash & cash equivalents, inventories, and property, plant and equipment. Question

13 Mall Exercise: Two Shareholders  Determine ABC’s shareholders’ expected returns at the time the land is purchased assuming they believe there is a 50% chance the mall will be approved. Question: Part a4 Return to menu

14 Mall Exercise: Two Shareholders ABC’s shareholders’ expected returns: Solution: Part a4 $250$1,000 $50$ %-50%25%100%-50%25% Return to menu

15 Mall Exercise: Two Shareholders  Without additional information, we can’t determine whether the 25% expected return is reasonable given the related risks:  To this end, the shareholders would need to compare this investment to expected returns on other investment opportunities with comparable risk.  At the time of the purchase, the two shareholders could have different assessments of the probability that the mall would be approved, and thus, different assessments of the payoffs. Additionally, their assessments could differ from those of ABC’s management.  As a result, the three parties’ perceptions about the related risks and the reasonableness of the investment could differ. Take Away Return to menu

16 Mall Exercise: One Shareholder & One Bank  On 01/01/2009, ABC Company:  Issues $200 worth of stock to shareholder A  Issues $800 worth of debt to First Bank with 10% per year interest  On 01/02/2009, ABC purchases land for $1,000  Next to planned shopping mall  Mall still needs approval from regulators  ABC expects to resale the land at the end of 2009:  For $2,000 if mall approved  For $500 if mall not approved Things You Need to Know Return to menu

17 Mall Exercise: One Shareholder & One Bank  On 12/28/2009, ABC learns whether mall is approved  On 12/30/2009, ABC sells the land  For $2,000 if mall approved  For $500 if mall not approved  On 12/31/2009, ABC distributes its cash to investors Things You Need to Know Return to menu

18 Mall Exercise: One Shareholder & One Bank  Determine ABC’s balance sheet possibilities: Question: Part b1 Return to menu

19 Mall Exercise: One Shareholder & One Bank ABC’s balance sheet possibilities: Solution: Part b1 Consolidated Balance Sheet 12/30/2009, Pre Payoffs1/2/20091/1/2009 Mall approved Mall not approved After land acquired After financing Assets Cash and equivalents PP&E Total assets Liabilities and stockholders' equity Debt Stockholders' equity: Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $0 $1,000 $800 $200 $0 $200 $1,000 $0 $1,000 $800 $200 $0 $200 $1,000 Return to menu

20 Mall Exercise: One Shareholder & One Bank  Determine ABC’s shareholders’ gain/loss possibilities: Question: Part b2 Return to menu

21 Mall Exercise: One Shareholder & One Bank ABC’s shareholders’ gain/loss possibilities: Solution: Part b2 $880$500$1,120$0 $80($300)$920($200) Return to menu

22 Mall Exercise: One Shareholder & One Bank ABC’s balance sheet possibilities: Solution: Part b3 Consolidated Balance Sheet 12/30/2009, Pre Payoffs1/2/20091/1/2009 Mall approved Mall not approved After land acquired After financing Assets Cash and equivalents PP&E Total assets Liabilities and stockholders' equity Debt Stockholders' equity: Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $2,000 $0 $2,000 $500 $0 $500 $880$500 $200 $920($200) $1,120$0 $2,000$500 $0 $1,000 $800 $200 $0 $200 $1,000 $0 $1,000 $800 $200 $0 $200 $1,000 Return to menu

23 Mall Exercise: One Shareholder & One Bank  What has not changed in part (b) versus part (a)?  What has changed? Why? Question: Part b4 Return to menu

24 Mall Exercise: One Shareholder & One Bank  The asset risk is the same—the risk the land value will decrease.  Shareholder A is now the sole owner.  ABC now has financial leverage: Liabilities/assets = 80%.  Shareholder A has a much larger upside and downside.  First Bank has a much bigger downside than upside.  Without knowing First Bank’s assessment of the probability of the mall’s approval, we can’t determine the bank’s perception of its risk.  Similarly, we can’t determine whether this assessment is reasonable without knowing more about the context. Take Away Return to menu

25 Mall Exercise: One Shareholder & One Bank  Determine the investors’ expected returns at the time the land is purchased, assuming they believe there is a 50% chance the mall will be approved.  Evaluate the bank credit analyst who approved the loan. Question: Part b5 Return to menu

26 Mall Exercise: One Shareholder & One Bank  ABC’s investors’ expected returns are reported below. Solution: Part b5 $690$560 ($110)$360 10%-38%-14%460%-100%180%  The bank’s credit analyst gets a failing grade—the expected return is negative. Return to menu

27 Mall Exercise: One Shareholder & One Bank  Determine the probability of approval needed for First Bank to expect to earn an 8% return on its investment. Question: Part b6 Return to menu

28 Mall Exercise: One Shareholder & One Bank  The probability of approval would need to be 95.83%. This is the “p” that solves the following: (10%) * p + (-38%) * (1-p) = 8% Solution: Part b6 Return to menu

29 Mall Exercise: One Shareholder & One Bank  Given the 50% approval probability, First Bank could have done several things to structure the loan better:  Raise the interest rate considerably  If the interest rate had been 53.5%, First Bank would have expected an 8% return on the investment.  Require Shareholder A to pay a larger portion of the $1,000 investment, which lowers ABC’s financial leverage.  If the loan had been for $471.7 instead of $800, First Bank would have expected an 8% return on the investment.  Bad credit decisions often occur during real estate booms:  If the land price had recently increased from $500 to $1,000 because of risk seekers betting on mall approval or there was a real estate bubble, banks might have underestimated losses. Take Away Return to menu

30 Mall Exercise: One Shareholder & Two Banks  On 01/01/2009, ABC Company  Issues $200 worth of stock to shareholder A  Issues $800 worth of debt to First Bank with 10% per year interest  Issues $1,000 worth of subordinate debt to Second Bank, with a 15% rate  On 01/02/2009, ABC purchases two parcels land for $2,000  Next to planned shopping mall  Mall still needs approval from regulators  ABC expects to resale the land at the end of 2009:  For $4,000 if mall approved  For $1,000 if mall not approved Things You Need to Know Return to menu

31 Mall Exercise: One Shareholder & Two Banks  On 12/28/2009, ABC learns whether mall is approved  On 12/30/2009, ABC sells the land  For $4,000 if mall approved  For $1,000 if mall not approved  On 12/31/2009, ABC distributes its cash to investors Things You Need to Know Return to menu

32 Mall Exercise: One Shareholder & Two Banks  Determine ABC’s balance sheet possibilities: Question: Part c1 Return to menu

33 Mall Exercise: One Shareholder & Two Banks  Determine ABC’s balance sheet possibilities: Solution: Part c1 $0$2,000 $0 $2,000 $1,800 $200 $0 $200 $2,000 Return to menu

34 Mall Exercise: One Shareholder & Two Banks  Determine ABC’s shareholders’ gain/loss possibilities: Question: Part c2 Return to menu

35 Mall Exercise: One Shareholder & Two Banks ABC’s shareholders’ gain/loss possibilities: Solution: Part c2 $200 $1,970$0 $1,770($200) $1,000 $1,150$120 $150($880) $800 $880 $80 Return to menu

36 Mall Exercise: One Shareholder & Two Banks  Determine ABC’s balance sheet possibilities: Solution: Part c3 $0$2,000 $0 $2,000 $1,800 $200 $0 $200 $2,000 $4,000 $0 $4,000 $2,030 $200 $1,770 $1,970 $4,000 $1,000 $0 $1,000 $0 $1,000 $200 ($200) Return to menu

37 Mall Exercise: One Shareholder & Two Banks  What has not changed in part (c)?  What has changed? Why? Question: Part c4 Return to menu

38 Mall Exercise: One Shareholder & Two Banks  Shareholder A has the same downside but a bigger upside.  First Bank has no risk because Second Bank has effectively provided a safety cushion through subordination.  Second Bank’s credit analyst has made so many blunders; First Bank’s credit analyst has managed to escape a really bad deal.  When companies have nothing else to lose, they have a strong incentive to gamble with other people’s money.  Risk and reward go together when everyone behaves rationally.  Second Bank was not acting rationally, and as a result, Shareholder A’s and First Bank’s rewards increased, but not their risks. Take Away Return to menu

39 Closing Thoughts  The concepts and lessons discussed here were center stage in the credit crisis:  Real estate prices increased dramatically in many areas of the world during  Credit controls were very weak:  No down payments were required.  Customers without safety nets could barely make payments in good times.  Banks sold loans for a profit shortly after they were initiated, and thus, they had no incentive to control credit risks. Return to menu

40 Closing Thoughts  Owners of Bear Stearns’ common stock realized the risks associated with financial leverage in March, 2008 when the value of their shares fell to $2 per share, after being worth more than $90 two months earlier.  Measured as liabilities divided by assets, Bear Stearns’ financial leverage was 97% on November 30, 2007 (the end of the fiscal year prior to the company’s downfall) and a good deal of its assets were very susceptible to risks associated with mortgages.  Towards the end of 2007 it became apparent that the risks associated with mortgages and related securities were considerably higher than most investors expected.  The compounding effect of Bear Stearns’ high financial leverage and high asset risk amplified the owners’ risk tremendously. Return to menu