Columbia Class #2 Intro

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University of Pennsylvania *

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520

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Finance

Date

Jan 9, 2024

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pdf

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Uploaded by WooyeoCho

Class #2 Recap class #1: • The accounting rules were designed for a time when the value of an enterprise resided in hard assets and financial assets. This means amounts expended in buying or building hard assets such as a factory, are capitalized on the balance sheet. The P&L is subsequently hit over time with depreciation charges as the factory is used. Investments in developing intangibles such as a brand are generally expensed as the cash goes out the door. In the current economy, for many companies the value is compromised mostly of intangibles. This yields the odd result of many loss-making public companies. • ESG is the topic du jour in the C-Suite. ESG reporting is therefore coming into focus. The central premise of ESG is that things that are important to key stakeholders such as customers, employees and the general public are ultimately important the resilience of a company’s business model. Imagine you are a consumer products company. How might ESG reporting provide insights on the company’s intangible assets that the financial state ments do not? JV’s and Alliances Last class we discussed a company acquiring an asset through various means. The next level of complexity is a JV or an alliance. We will focus on JVs in class, but most of the concepts translate to alliances and other types of investments. Companies will often partner, because they are unable to buy the asset/capability they need or building/developing it would be too expensive/risky or time consuming, or perhaps they just need expertise that another party possesses. Said differently, sometimes what you need is not for sale, so the only way to get access to it is through a partnership. We will discuss the common motivations for JV’s and other investments that involve significant governance rights, but not outright control (M&A is when control is obtained and will be discussed next week). The business motivations and other consideration drive the structure of the arrangement, which in turn impacts how it is reported in the financial statements. A few key points to keep in mind: • The JV partners may have different financial reporting objectives when entering into a JV (e.g. Big Pharma vs a biotech). Why might this be? • The two parties (note there could be more than two parties) may have different reporting for the venture. • Structure is very important, particularly how the governance works Consider this example to be discussed in class. Company A determines it needs to expand its chipmaking capacity. It could build a new plant with a capacity of 1,000 chips per year for $100. A larger plant, with a capacity of 2,000 chips per year would cost $180 and have a lower cost per unit due to economies of scale. The company does not have a need for more that 1,000 chips per year for the foreseeable future. It could enter into a 50/50 JV with a third party to build the larger plant. If the construction can be financed 80% will debt, how would the financial statements be different in the two scenarios? How would your answer change if Company A used the chips as an input for one of its products, vs it is in the business of selling chips? The presentation in the financial statements of assets and liabilities is quite different depending on the rights a company has. Broadly there are three types of rights:

• A company has control of the asset, subsidiary etc and thus presents the related assets and liabilities in its financial statements. These are the fact patterns we discussed in the Class #1. • A company has significant influence. A JV is an example. To be a joint venture from an accounting perspective, neither party has unilateral control. Note that the term joint venture in the business press is broader than the accounting concept and includes some situations where one of the parties has significantly more governance rights than the other. When a company has significant influence, it only has a single asset in its balance sheet (i.e., investment in JV). This means that the individual assets and liabilities of the JV are not reflected in the balance sheet of the venturer. Similarly, in the P&L, the results of the JV are compressed into a single line often called investments in associates and JVs. The amount recorded in the venturer’s P&L is generally determined by applying the equity method. In the simplest fact patterns, this means that if a venturer owns 50% of the equity of a JV, then it will record an amount in its P&L equal to 50% of the profit of the JV in each period. • If a company has limited or no governance rights, the investment is in balance sheet as a single line item and is generally remeasured each time period at fair value. The change in the value hits the P&L. There are a lot of nuances to these types of investments that are beyond the scope of this class. Review the JV deck in advance of class. Note the examples of disclosures made by companies with respect to large JVs. There is a second deck that goes into considerable detail on common challenges with applying the equity method in practice. We will touch on a few topics. Mostly this deck is for your reference. Finally, in the JV deck there is a discussion of R&D funding structures. This is a form of alliance. While the company in question is not well know, we use this as an illustration because the transaction is very material and therefore there is a lot of disclosure. What business issues is this transaction trying to solve? What do the funds provided by Symphony represent economically from Alexza’s perspective? How would the key financial metrics of Alexza look had they just funded the R&D themselves? How would this impact EBITDA?

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