3 - 1 © 2005 Accounting 1/e, Terrell/Terrell Organizing a Business: Equity and Debt Financing Chapter 3

3 - 2 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Identify the steps to organizing a business.

3 - 3 © 2005 Accounting 1/e, Terrell/Terrell Checklist Before Beginning Operations International Accounting Associates LLP Client Checklist Before Beginning Operations 1. Find competent people to be responsible for the four functions of the firm. 2. Decide upon the organizational form for the business. 3. Research the industry and the product. 4. Prepare a strategic plan. 5. Design internal controls for operations and information. 6. Secure financing. 7. Prepare initial capital and operating budgets.

3 - 4 © 2005 Accounting 1/e, Terrell/Terrell The Four Functions of the Firm Financing Decision making Operating Investing

3 - 5 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 2 Describe a corporate organization structure and define the equity structure of a corporation.

3 - 6 © 2005 Accounting 1/e, Terrell/Terrell Forming a Corporation 1. Basic information about the corporation 2. Name of the incorporators 3. Details concerning the types and amounts of stock authorized amounts of stock authorized Incorporators are the persons who submit a formal application to create a corporation and file it with the appropriate state agency. Articles of incorporation is an application for incorporation.

3 - 7 © 2005 Accounting 1/e, Terrell/Terrell Corporate Organizational Structure Stockholders own the corporation. A stock certificate is a legal document providing evidence of ownership and containing the provisions of the stock ownership agreement.

3 - 8 © 2005 Accounting 1/e, Terrell/Terrell Corporate Organizational Structure Chief Operating Officer Treasurer The board of directors has ultimate responsibility for managing the corporation. for managing the corporation. Chief Executive Officer Corporate Secretary

3 - 9 © 2005 Accounting 1/e, Terrell/Terrell Corporate Organizational Structure Vice Presidents Board of Directors Chief Financial Officer Stockholders Chief Executive Officer Chief Operating Officer Corporate Secretary TreasurerController

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 3 Compare and contrast the characteristics of common stock and preferred stock.

© 2005 Accounting 1/e, Terrell/Terrell Corporate Capital Structure Outstanding shares are the number of shares currently held by stockholders Treasury stock are shares reacquired by the corporation. Authorized shares are the maximum number of shares the charter allows the corporation to issue. Issued shares are shares of stock sold to stockholders.

© 2005 Accounting 1/e, Terrell/Terrell Corporate Capital Structure Par value is an arbitrary dollar amount placed on the stock by the incorporators. No-par stock is stock authorized without a par value. Common stock is the voting stock of the corporation. Common stockholders are the residual owners of the corporation.

© 2005 Accounting 1/e, Terrell/Terrell Corporate Capital Structure Liquidation is the process of going out of business. Preferred stock offers certain preferential treatment to its owners over common stockholders. Owners of preferred stock must receive a dividend before any dividend is paid to owners of common stock.

© 2005 Accounting 1/e, Terrell/Terrell Corporate Capital Structure Additional paid-in capital is the amount paid to a corporation for stock in excess of its par value.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Research an industry for its particular characteristics and identify its major competitors.

© 2005 Accounting 1/e, Terrell/Terrell Researching the Industry An industry is a group of companies that form a sector of the economy.

© 2005 Accounting 1/e, Terrell/Terrell Researching the Industry Trade organizations Market research firms How does one research an industry? Industry guides Business periodicals

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 5 Prepare a strategic plan for a business.

© 2005 Accounting 1/e, Terrell/Terrell Developing a Strategic Plan A strategic plan describes the organizational approach the senior management of a company will employ... to fulfill the corporate mission and vision and achieve the stated goals by allocating financial resources and directing human resources. achieve the stated goals by allocating financial resources and directing human resources.

© 2005 Accounting 1/e, Terrell/Terrell Developing a Strategic Plan Develop a clearly articulated mission and vision. Set measurable goals and objectives. Scan the internal environment and assess the external environment. Formulate alternative strategies.

© 2005 Accounting 1/e, Terrell/Terrell Developing a Strategic Plan Develop the strategic plan by selecting the best alternatives and determining the activities needed to accomplish the stated goals. Implement the plan. Evaluate the results of the implementation and return to step 1.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 6 Outline internal controls for operations.

© 2005 Accounting 1/e, Terrell/Terrell Designing Internal Controls for Operations and Information The internal control structure helps to protect the business against preventable losses and to promote efficient operations by creating checks and balances within the accounting and operating processes.

© 2005 Accounting 1/e, Terrell/Terrell Designing Internal Controls for Operations and Information Protecting physical assets Protecting proprietary information Creating an environment that respects internal controls

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 Define borrowing terms and compute the cost of borrowing.

© 2005 Accounting 1/e, Terrell/Terrell Securing Financing Financing Equity financing Debt financing

© 2005 Accounting 1/e, Terrell/Terrell Securing Financing Interest is the cost of borrowing. Short-term financing is any borrowing that must be repaid within five years. Long-term financing has a repayment period that extends past five years.

© 2005 Accounting 1/e, Terrell/Terrell Borrowing with Notes Payable DefaultCollateral A note payable is a written agreement or debt instrument between a lender and a borrower that creates a liability for the borrower to repay both principal and interest. Promissory note

© 2005 Accounting 1/e, Terrell/Terrell The Cost of Borrowing Kenfield Inc. borrowed $5,000 on March 2, 2002, by signing an 8%, three-year note. The lender requires annual interest payments to be made on the anniversary of the note. What is the important information?

© 2005 Accounting 1/e, Terrell/Terrell The Cost of Borrowing $ 5,000Pleasanton, California March 2, 2002 Three years form date of issue we promise to pay to the order of Slippery Company Five-Thousand and 00/100 Dollars Payable at: National Bank Interest: 8% ($400) to be paid annually at anniversary date No. 115Principal is Due: March 2, 2005 Kenfield, Inc. Paul Mack, Treasurer Principal Date of issue Interestrate Loan length Interest payments due

© 2005 Accounting 1/e, Terrell/Terrell The Cost of Borrowing What is the formula to determine the annual interest? $5,000 x.08 = $400

© 2005 Accounting 1/e, Terrell/Terrell The Cost of Borrowing Amount repaid$6,200 Amount received from the loan 5,000 Cost of borrowing or interest$1,200 What is the interest if the funds are held for three months? $5,000 x.08 x 3/12 = $100

© 2005 Accounting 1/e, Terrell/Terrell The Cost of Borrowing What would be the interest if the note reads “$5,000, 8%, 90 day note?” $5,000 x.08 x 90/365 = $98.63

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 8 Compute and distinguish between nominal and effective interest rates.

© 2005 Accounting 1/e, Terrell/Terrell Effective Interest Rate Kenfield Inc. deposited $9,000 as the loan proceeds of a $10,000 discounted note due one year from today. Amount repaid$10,000 Amount received from the loan 9,000 Cost of borrowing (interest)$ 1,000

© 2005 Accounting 1/e, Terrell/Terrell Effective Interest Rate

© 2005 Accounting 1/e, Terrell/Terrell Borrowing Through the Financial Markets Bond indenture is an agreement. The nominal interest rate is the rate that the issuing corporation agreed to pay in the bond indenture. corporation agreed to pay in the bond indenture. Commercial paper is a corporate promissory note that investors buy from the corporation. that investors buy from the corporation. Bond is a type of long-term note payable.

© 2005 Accounting 1/e, Terrell/Terrell Borrowing Through the Financial Markets The effective interest rate of a bond denotes the actual interest rate that the bondholder will earn. Yield rate Market interest rate

© 2005 Accounting 1/e, Terrell/Terrell Borrowing Through the Financial Markets The selling price of a bond is also called the market price. Discount occurs when a bond sells for less than par value.

© 2005 Accounting 1/e, Terrell/Terrell Borrowing Through the Financial Markets Premium occurs when a bond sells for more than par value. The primary securities market involves sales of newly issued stocks and bonds between the issuing corporation and investors.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 9 Compute the selling price of bonds with a calculator.

© 2005 Accounting 1/e, Terrell/Terrell Computing the Selling Price of Bonds n Number of interest payment periods i Effective interest rate per period FV Maturity value p Cash interest paid each period PV Selling price of the bonds cpt

© 2005 Accounting 1/e, Terrell/Terrell Computing the Selling Price of Bonds If Jupiter Corporation desired to sell $1,000,000 of 20-year bonds with a nominal rate of 11% when the market expects to receive 10.5 interest... what would be the bonds’ selling price?

© 2005 Accounting 1/e, Terrell/Terrell Amortization Table Lenders frequently provide an amortization that details the payments of principal and interest on loans.

© 2005 Accounting 1/e, Terrell/Terrell End of Chapter 3