ALPFA National Convention KPMG Case Competition

InfoMemo Audit 2.0 Citlali Perez, Saida Schmidt, Jacob Brownfield, Justin Ricaurte

Scenario
Start-up company preparing to launch a mini-laptop
Needs $15 million
Two current options:
Bank Loan
Investor Convertible Bond

Loan
10- year
20% Interest
Bond
10-year
10% interest
Convertible

Outline
Explanation of Term Sheet
Consequences of Term Sheet
Scenario 1
Scenario 2
Analysis of Financing Options

Explanation of Term Sheet

Debt converted into common stock at the creditor’s option.
Convertible Bond Stock Bond

Accounting Guidance
APB 14
FAS 133
FAS 84
EITF 98-5
EITF 00-27

1/1/X1
Dr. Cash $15M
Cr. Bonds Payable $15M
The Balance Sheet Journal Entry for the issuance of the bond

12/31/X1,X2…10
Dr. Bond Interest Expense $1.5M
Cr. Cash $1.5M
If interest accrued:
Dr. Bond Interest Expense $1.5M
Cr. Bond Interest Payable $1.5M
Journal Entries to record payment on interest

Consequences of Term Sheet Scenario 1

Assumptions
No discount or premium to be amortized
No debt issuance costs
Paid interest each year

Conversion After 5 Years
*Assuming $1 Par Value
1/1/X6 Dr. Bonds Payable $15M Cr. Common Stock $ 1.5M Cr. APIC $13.5M

Effect on EPS
Prior to Conversion
Net Income $10,000,000
Outstanding Shares 2M
EPS $5.00
After Conversion
Net Income $10,000,000
Outstanding Shares 2M + 1.5M
EPS $2.86

Sample Footnote Disclosure 0.62 $ 0.48 $ 0.64 $ Diluted net income per share 0.7 $ 0.55 $ 0.72 $ Basic net income per share 69,412 76,516 85,919 Shares used in computation of diluted net income per share 2,548 6,163 6,163 Add: Dilutive effect of convertible debt 5,639 6,254 5,017 Add: Dilutive effect of employee stock options 61,225 64,099 74,739 Shares used in computation of basic net income per share — — (108 Less: Weighted average common shares subject to repurchase 61,225 64,099 74,847 Gross weighted average common shares outstanding Shares (denominator for basic and diluted): 43,321 $ 36,602 $ 55,369 $ Adjusted net income (numerator for diluted) 438 1,421 1,415 Add: Interest expense on convertible notes, net of tax 42,883 $ 35,181 $ 53,954 $ Net income (numerator for basic) 2004 2005 2006 Year Ended December 31,

Consequences of Term Sheet: Scenario 2

Beneficial Conversion Feature Effective Conversion Price $10 < Fair Value of the Stock (@ commitment date) $12 Convertible debt instrument includes a beneficial conversion feature for which a value must be assigned.

Valuation of Beneficial Conversion Feature
Fair Value of Stock $12
Conversion Price ($10)
Intrinsic Value $2
# of shares x 1.5M
Total Intrinsic Value = $3M

Journal Entries for Beneficial Conversion
1/1/X1
Dr. Cash $15M
Dr. Bond Discount $3M
Cr. Bond Payable $15M
Cr. APIC $3M

Interest Expense and Bond Discount Amortization
Debt discount…should be amortized as a component of interest expense.
$3M/10yrs = $300K/yr
*Note: Should use the Effective Interest Rate Method to calculate amortization per EITF 00-27, pars. 19-20

Journal Entries for Beneficial Conversion
12/31/X1,X2…X7
Dr. Interest Expense $1.5M
Cr. Interest Payable $1.5M
Dr. Interest Expense $300K
Cr. Bond Discount Amort. $300K

All unamortized bond discount  Interest Expense
$3M/10yrs = $300K/yr
$3M – (7yrs x $300K/yr) = $900K
Increase equity upon conversion of debt by an amount equal to the carrying value of the debt
Bonds Payable = $15M
Accounting for Unamortized Bond Discount upon Conversion

Journal Entries for Beneficial Conversion (After IPO)
IPO: 1/1/X8
Dr. Interest Expense $900K
Cr. Bond Discount Amort. $900K
Dr. Bond Payable $15M
Cr. APIC $15M

Analysis of Financing Options InfoMemo

Alternative Financing Instruments
Common Stock
Bridge Loan
Preferred Stock

Investment Assumptions
Company lasts for at least 10 years
Investor has 50/50 probability of converting to stock

Key Good Bad

Equity Dilution
Cost
Loss of Control
Investor-Company Interests Aligned
What InfoMemo Cares About

What InfoMemo Cares About Cost Lost Control Aligned Interests Common Bridge Convertible Preferred Loan Good Bad Dilution

Potential ROI
Taxes
Risk
What the Investor Cares About

What the Investor Cares About ROI Risk Taxes Common Bridge Convertible Preferred Loan Good Bad

The Convertible Bond Dilution Cost Lost Control Aligned Interests ROI Risk Taxes

Recommendation
Currently, Convertible Bond best option
Solicit More Investors

Questions? InfoMemo

ALPFA National Convention KPMG Case Competition

by ricaurte on Aug 09, 2007

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ALPFA National Convention KPMG Case Competition — Presentation Transcript