Q: Define off balance sheet financing (OBSF)? Discuss its effects and give examples.

Ans: Off-balance sheet financing is any means that secures the use of assets for the firm without having to recognize an off-setting liability. If the liability is not recognized, then the double-entry system does not allow for the recognition of the asset either, but this is a tradeoff that some managers are willing to make. Effects: Off-balance-sheet financing can affect key financial ratios, especially the financing ratios that use total debt as a denominator, showing them to be lower (and more favorable) than they would be if the financing were recognized.

Improve Chances With Investors: One reason a company might use off-balance sheet financing is to appear more attractive to investors. When investors look at a company, they often use financial ratios to make decisions . For example, they might consider the debt-to-equity ratio of the company. With an off-balance sheet financing arrangement, the company can avoid going further into debt to acquire an asset. This allows the company to use the asset but avoid increasing the debt-to-equity ratio. Improve Chances of Getting Loan Off-balance sheet financing also can make it easier for a company to get approved for financing. Before a company can obtain loan approval, a lender typically looks at its debt-to-equity ratio and several other factors. When the company uses off-balance sheet financing to acquire equipment and assets, it can leave its credit lines open. This results in the company being more likely to qualify for a loan.

Window dressing Examples: Operating leases: Leases that are in substance purchase, called capital lease and appear on balance sheet. However the lease, which is not in, the substance purchases are operating leases. In this case of operating lease the lessee accounts for the minimum lease payment as a rental expense (revenue) and no asset or liability is recognized on the balance sheet. Take-or-pay agreements: in this case a firm agrees to pay for goods in the future regardless of whether it takes the delivery or not. Third party agreements: a third party purchases an asset for the firm and the firm agrees to service the third partys debt on the purchase. Pensions (elaborate)

Define economic income and permanent income? Critically assess their implications for forecasting and equity?

Answer: Economic income (EI)is a term that is used to describe the amount of income that an entity can comfortably spend during a specified period of time and be in essentially the same financial position at the end of the period as at the beginning. Sometimes referred to as surplus, this type of income is what is left over after all basic financial commitments are fulfilled, and can be spent freely without endangering the entitys financial standing in any way. Both households and businesses generate economic income, and can choose to use this income in several different ways. From book: Economic income is typically determined as cash flow during the period plus change in the present value of expected future cash flows, typically represented by the change in the market value of the businesss net assets. Income includes both the realized (cash flow) and unrealized gains (holding gains and losses) Permanent income: (PI) It is the stable average income that a business is expected to earn over its life, given the current state of its business conditions. It reflects the longterm focus. Unlike the economic income, which measures the change in the company value, PI is directly proportional to the company value. For going concern, company value can be expressed by dividing permanent income by the cost of capital. Because of this relation, determining the PI is a major quest for many analysts. However, PI has long-term connotation, it can change whenever the long-term earnings prospects of a company are altered.

Q: Describe the purpose of Special purpose entities? Why have become popular in the past decade? Critically discuss how they could be utilized as a way of off-balance sheet financing with one example? A: SPEs allow companies provide off-balance sheet financing yet allow the organisation to retain all of the tax benefits of ownership. Some of the reasons for creating special purpose entities are: Securitization: SPEs are commonly used to securitise loans (or other receivables). For example, a bank may wish to issue a mortgagebacked security whose payments come from a pool of loans. However, to ensure that the holders of the mortgage-back securities have the first priority right to receive payments on the loans, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPE, and then transferring the loans from the bank to the SPE. Risk sharing: Corporates may use SPEs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk. Finance: Multi-tiered SPEs allow multiple tiers of investment and debt. Asset transfer: Many permits required to operate certain assets (such as power plants) are either non-transferable or difficult to transfer. By having an SPE own the asset and all the permits, the SPE can be sold as a self-contained package, rather than attempting to assign over numerous permits. To maintain the secrecy of intellectual property: For example, when Intel and Hewlett-Packard started developing IA-64 (Itanium) processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals.[citation needed] Financial engineering: SPEs are often used in financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. The Enron case is possibly the most famous example of a company using SPEs to achieve the latter goal. Regulatory reasons: A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific assets. Property investing: Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property

be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes. Some examples: 1. A company sells accounts receivable to SP. These receivables may arise for e.g. from the companys proprietary credit card that it offers its customers to attempt to ensure their future patronage (e.g. the Target credit card). The Security company interest in
Receivables receivables
Sponsoring company

SPE
Cash Cash

Bond market

removes the receivables from their balance sheet and receives cash that can be invested in other earning assets. The SPE collateralizes the bonds that it sells in the credit markets with the receivables and uses the cash to purchase additional receivables on a n ongoing basis as the companys credit card portfolio grows. This process is called Securitization. Consumer finance companies like capital one are significant issuers of receivables-backed bonds. 2. A company desires to construct a manufacturing facility. It executes a contract to purchase the output of plant. A SPE uses the contract and the property to collateralize bonds that it sells to finance the plants construction. The company obtains benefits of manufacturing plants, but does not recognise either assets or the liablilities on its balance sheet since executory contracts are not recorded under GAAP and are also not considered derivatives that would require balance sheet recognition. 3. A company desires to construct an office building but does not want to record either the assets or the liabilities on its balance sheet. A SPE agrees to finance and construct the building and lease it to the company under as operating lease, called a synthetic lease. If structured properly, neither leased asset nor the lease obligation are reflected n the companys balance sheet.
Security interest in lease contract

Lease Contract Sponsoring Company CASH

SPE
CASH

Bond Market