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Ch 02 - The Business, Tax, And Financial Environments

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Financial Management by Van Horne …

Financial Management by Van Horne
Ch 02 - The Business, Tax, And Financial Environments

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  • 1. 1Chapter 2Chapter 2The Business, Tax,The Business, Tax,and Financialand FinancialEnvironmentsEnvironments© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
  • 2. 2The Business, Tax, andThe Business, Tax, andFinancial EnvironmentsFinancial EnvironmentsThe Business EnvironmentThe Tax EnvironmentThe Financial Environment
  • 3. 3The BusinessThe BusinessEnvironmentEnvironmentSole ProprietorshipsPartnerships (general and limited)CorporationsLimited liability companiesThe U.S. has four basic forms ofThe U.S. has four basic forms ofbusiness organization:business organization:
  • 4. 4The BusinessThe BusinessEnvironmentEnvironmentOldest form of business organization.Business incomeBusiness income is accounted for onthe owner’s personalpersonal income tax formincome tax form.Sole ProprietorshipSole Proprietorship -- A businessform for which there is one owner.This single owner has unlimitedliability for all debts of the firm.
  • 5. 5Summary forSummary forSole ProprietorshipSole ProprietorshipAdvantagesAdvantagesSimplicityLow setup costQuick setupSingle tax filingon individual formDisadvantagesDisadvantagesUnlimited liabilityHard to raiseadditional capitalTransfer ofownershipdifficulties
  • 6. 6The BusinessThe BusinessEnvironmentEnvironmentBusiness incomeBusiness income is accountedfor on each partner’s personalpersonalincome tax formincome tax form.PartnershipPartnership -- A business form inwhich two or more individualsact as owners.
  • 7. 7Types of PartnershipsTypes of PartnershipsLimited PartnershipLimited Partnership -- Limited partnershave liability limited to their capitalcontribution (investors only). At leastone general partner is required and allgeneral partners have unlimited liability.General PartnershipGeneral Partnership -- All partners haveunlimited liability and are liable for allobligations of the partnership.
  • 8. 8Summary for PartnershipSummary for PartnershipAdvantagesAdvantagesCan be simpleLow setup cost, higherthan soleproprietorshipRelatively quick setupLimited liability forlimited partnersDisadvantagesDisadvantagesUnlimited liability forthe general partnerDifficult to raiseadditional capital, buteasier than soleproprietorshipTransfer of ownershipdifficulties
  • 9. 9The BusinessThe BusinessEnvironmentEnvironmentAn artificial entity that can ownassets and incur liabilities.Business incomeBusiness income is accountedfor on the income tax form of theincome tax form of thecorporationcorporation.CorporationCorporation -- A business formlegally separate from its owners.
  • 10. 10Summary for CorporationSummary for CorporationAdvantagesAdvantagesLimited liabilityEasy transfer ofownershipUnlimited lifeEasier to raise largequantities of capitalDisadvantagesDisadvantagesDouble taxationMore difficult toestablishMore expensiveto set up andmaintain
  • 11. 11The BusinessThe BusinessEnvironmentEnvironmentBusiness incomeBusiness income is accounted for oneach “member’s” individual income taxindividual income taxformform.Limited Liability CompaniesLimited Liability Companies -- Abusiness form that provides its owners(called “members”) with corporate-style limited personal liability and thefederal-tax treatment of a partnership.
  • 12. 12Limited LiabilityLimited LiabilityCompany (LLC)Company (LLC)Limited liabilityCentralized managementUnlimited lifeTransfer of ownership without otherowners’ prior consentGenerally, an LLC will possess only theGenerally, an LLC will possess only thefirst two of the following four standardfirst two of the following four standardcorporation characteristicscorporation characteristics
  • 13. 13Summary for LLCSummary for LLCAdvantagesAdvantagesLimited liabilityEliminates doubletaxationNo restriction onnumber or type ofownersEasier to raiseadditional capitalDisadvantagesDisadvantagesLimited life(generally)Transfer ofownershipdifficulties(generally)
  • 14. 14Corp. Taxable Income TaxAt Least But < Rate Tax Calculation$ 0 $ 50,000 15% .15x(Inc > 0)50,000 75,000 25% $ 7,500 + .25x(Inc > 50,000)75,000 100,000 34% 13,750 + .34x(Inc > 75,000)100,000 335,000 39% 22,250 + .39x(Inc > 100,000)335,000 10,000,000 34% 113,900 + .34x(Inc > 335,000)10,000,000 15,000,000 35% 3,400,000 + .35x(Inc > 10,000,000)15,000,000 18,333,333 38% 5,150,000 + .38x(Inc > 15,000,000)18,333,333 35% 6,416,667 + .35x(Inc > 18,333,333)Corporate Income TaxesCorporate Income Taxes
  • 15. 15Income Tax ExampleIncome Tax ExampleLisa Miller of Basket Wonders(BW) is calculating the income taxincome taxliabilityliability, marginal tax ratemarginal tax rate, andaverage tax rateaverage tax rate for the fiscal yearending December 31.BW’s corporate taxable income forthis fiscal year was $250,000.
  • 16. 16Income Tax ExampleIncome Tax ExampleMarginal tax rateMarginal tax rate = 39%39%Average tax rateAverage tax rate = $80,750 / $250,000= 32.3%32.3%Income tax liability= $22,250 + .39 x ($250,000 - $100,000$100,000)= $22,250 + $58,500= $80,750
  • 17. 17DepreciationDepreciationGenerally, profitable firms prefer to usean accelerated method for taxreporting purposes.DepreciationDepreciation represents thesystematic allocation of the cost ofa capital asset over a period of timefor financial reporting purposes, taxpurposes, or both.
  • 18. 18Common Types ofCommon Types ofDepreciationDepreciationStraight-line (Straight-line (SLSL))Accelerated TypesAccelerated TypesDouble-Declining-Balance(DDB)Modified Accelerated CostRecovery System (MACRS)
  • 19. 19Depreciation ExampleDepreciation ExampleLisa Miller of Basket Wonders (BW)is calculating the depreciation on amachine with a depreciable basis of$100,000, a 6-year useful life6-year useful life, and a5-year property class life.She calculates the annualdepreciation charges using MACRS.
  • 20. 20MACRS ExampleMACRS ExampleAssets are depreciated based on oneof eight different property classes.Generally, the half-year convention isused.Depreciation in any particular year isthe maximum of DDB or straight-line.A switch in depreciation methods ismade from DDB to SL during the lifeof the asset.
  • 21. 21MACRS ExampleMACRS ExampleDepreciation Depreciation Net BookYear Calculation Charge Value0 --- --- $100,0001 .5X2X(1/5) X $100,000 $ 20,000 80,0002 2 X ( 1 / 5) X $80,000 32,000 48,0003 2 X ( 1 / 5) X $48,000 19,200 28,8004 $28,800 / 2.5 Years 11,520 17,2805 $28,800 / 2.5 Years 11,520 5,7606 $28,800 / 2.5 Yrs X .5 5,760 0
  • 22. 22MACRS ScheduleMACRS ScheduleRecovery Property ClassYear 3-Year 5-Year 7-Year1 33.33% 20.00% 14.29%2 44.45 32.00 24.493 14.81 19.20 17.494 7.41 11.52 12.495 11.52 8.936 5.76 8.927 8.938 4.46
  • 23. 23Other Tax IssuesOther Tax IssuesQuarterly Tax PaymentsQuarterly Tax Payments requirecorporations to pay 25% of theirestimated annual tax liability on the 15thof April, June, September, and December.Alternative Minimum TaxAlternative Minimum Tax is a special taxwhich equals 20% of alternative minimumtaxable income (generally not equal totaxable income). Corporations pay themaximum of AMT or regular tax liability.
  • 24. 24Interest DeductibilityInterest DeductibilityInterest ExpenseInterest Expense is the interest paid onoutstanding debt and is tax deductibletax deductible.Cash Dividend is the cash distribution ofearnings to shareholders and is not a taxdeductible expense.The after-tax cost of debtafter-tax cost of debt is:(Interest Expense) X ( 1 - Tax Rate)Thus, debt financing has a tax advantagetax advantage!
  • 25. 25Handling CorporateHandling CorporateLosses and GainsLosses and GainsLosses are generally carried backfirst and then forward starting withthe earliest year with operating gains.Corporations that sustain a netoperating loss can carry that lossback (Carryback) 2 years and forward(CarryforwardCarryforward) 20 years20 years to offsetoperating gains in those years.
  • 26. 26Corporate LossesCorporate Lossesand Gains Exampleand Gains ExampleLisa Miller is examining the impact ofan operating loss at Basket Wonders(BW) in 2003. The following time lineshows operating income and losses.What impact does the 2003 loss haveWhat impact does the 2003 loss haveonon BWBW??-$500,000-$500,000$100,000$100,000$150,000$150,000$150,000$150,0002003200220012000
  • 27. 27Corporate LossesCorporate Lossesand Gains Exampleand Gains ExampleThe loss can offset the gain in each ofthe years 2001 and 2002. Theremaining $250,000$250,000 can be carriedforward to 2004 or beyond.-$500,000-$500,000$100,000$100,000$150,000$150,000$150,000$150,0002003200220012000-$150,000-$150,000 -$100,000-$100,000 $250,000$250,000$150,000$150,000 0000 -$250,000-$250,000
  • 28. 28Corporate CapitalCorporate CapitalGains / LossesGains / LossesOften historically, capital gains incomehas received more favorable U.S. taxtreatment than operating income.Generally, the sale of a “capital asset”(as defined by the IRS) generates acapital gaincapital gain (asset sells for more thanoriginal cost) or capital losscapital loss (assetsells for less than original cost).
  • 29. 29Corporate CapitalCorporate CapitalGains / LossesGains / LossesCapital lossesCapital losses are deductible onlyagainst capital gainscapital gains.Currently, capital gainscapital gains are taxedat ordinary income tax rates forcorporations, or a maximum 35%.
  • 30. 30Personal Income TaxesPersonal Income TaxesThe U.S. has a progressive taxprogressive taxstructurestructure with four tax brackets of 15%15%,28%28%, 31%31%, and 36%36%.A 10% surtax10% surtax is applied to certain highincome individuals raising theirmarginal rate to 39.6%39.6%.Personal income taxes are determinedby taxable income, filing status, andvarious credits.
  • 31. 31Financial EnvironmentFinancial EnvironmentBusinesses interact continually withthe financial markets.financial markets.Financial MarketsFinancial Markets are composed of allinstitutions and procedures forbringing buyers and sellers of financialinstruments together.The purpose of financial markets is toefficiently allocate savings to ultimateusers.
  • 32. 32Flow of FundsFlow of Fundsin the Economyin the EconomyINVESTMENT SECTORFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKET
  • 33. 33Flow of FundsFlow of Fundsin the Economyin the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETINVESTMENTINVESTMENTSECTORSECTORBusinessesGovernmentHouseholdsINVESTMENTINVESTMENTSECTORSECTOR
  • 34. 34Flow of FundsFlow of Fundsin the Economyin the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSAVINGSSAVINGSSECTORSECTORHouseholdsBusinessesGovernmentINVESTMENTSECTOR
  • 35. 35Flow of FundsFlow of Fundsin the Economyin the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSFINANCIAL BROKERSSECONDARY MARKETFINANCIALFINANCIALBROKERSBROKERSInvestmentBankersMortgageBankersINVESTMENTSECTOR
  • 36. 36Flow of FundsFlow of Fundsin the Economyin the EconomyFINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETFINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIESCommercial BanksSavings InstitutionsInsurance Cos.Pension FundsFinance CompaniesMutual FundsINVESTMENTSECTOR
  • 37. 37Flow of FundsFlow of Fundsin the Economyin the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSECONDARY MARKETSECONDARYSECONDARYMARKETMARKETSecurityExchangesOTCMarketINVESTMENTSECTOR
  • 38. 38Allocation of FundsAllocation of FundsIn a rational world, the highest expectedreturns will be offered only by thoseeconomic units with the most promisinginvestment opportunities.ResultResult:: Savings tend to be allocated to themost efficient uses.Funds will flow to economic units that arewilling to provide the greatest expectedreturn (holding risk constant).
  • 39. 39Risk-ExpectedRisk-ExpectedReturn ProfileReturn ProfileRISKEXPECTEDRETURN(%)U.S. Treasury Bills (risk-free securities)U.S. Treasury Bills (risk-free securities)Prime-grade Commercial PaperPrime-grade Commercial PaperLong-term Government BondsInvestment-grade Corporate BondsMedium-grade Corporate BondsPreferred StocksConservative Common StocksSpeculative Common Stocks
  • 40. 40What Influences SecurityWhat Influences SecurityExpected Returns?Expected Returns?MarketabilityMarketability is the ability to sella significant volume of securitiesin a short period of time in thesecondary market withoutsignificant price concession.Default RiskDefault Risk is the failure to meetthe terms of a contract.
  • 41. 41Ratings by InvestmentRatings by InvestmentAgencies on Default RiskAgencies on Default RiskMOODY’S INV SERVICE STANDARD & POOR’SAaa Best Quality AAA Highest GradeAa High Quality AA High GradeA Upper Med Grade A Higher Med GradeBaa Medium Grade BBB Medium GradeBa Possess SpeculativeElementsBB SpeculativeC Lowest Grade D In DefaultInvestment gradeInvestment grade represents the top four categories.Below investment grade represents all other categories.
  • 42. 42What Influences ExpectedWhat Influences ExpectedSecurity Returns?Security Returns?TaxabilityTaxability considers the expectedtax consequences of the security.MaturityMaturity is concerned with the lifeof the security; the amount oftime before the principal amountof a security becomes due.
  • 43. 43Term Structure ofTerm Structure ofInterest RatesInterest RatesA yield curve is a graph of the relationship betweenyields and term to maturity for particular securities.Upward Sloping Yield CurveUpward Sloping Yield CurveDownward Sloping Yield Curve0246810YIELD(%)0 5 10 15 20 25 30(Usual)(Unusual)YEARS TO MATURITY
  • 44. 44What Influences ExpectedWhat Influences ExpectedSecurity Returns?Security Returns?InflationInflation is a rise in the averagelevel of prices of goods andservices. The greater inflationexpectations, then the greater theexpected return.Embedded OptionsEmbedded Options provide theopportunity to change specificattributes of the security.