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2-1Chapter 2The Business,Tax,The Business,Tax,and Financial and Financial EnvironmentsEnvironments Pearson Education Limited 2019Fundamentals of Financial Management,12/eCreated by:Gregory A.Kuhlemeyer,Ph.D.Carroll College,Waukesha,WI2-2After studying Chapter 2,you should be able to:1.Describe the four basic forms of business organization in the United States-and the advantages and disadvantages of each.2.Understand how to calculate a corporations taxable income and how to determine the corporate tax rate-both average and marginal.3.Understand various methods of depreciation.4.Understand why acquiring assets through the use of debt financing offers a tax advantage over both common and preferred stock financing.5.Describe the purpose and make up of financial markets.6.Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a securitys default risk.7.Understand what is meant by the term“term structure of interest rates”and relate it to a“yield curve.”2-3The Business,Tax,and Financial EnvironmentsuThe Business EnvironmentuThe Tax EnvironmentuThe Financial Environment2-4The Business EnvironmentuSole ProprietorshipsuPartnerships(general and limited)uCorporationsuLimited liability companiesThe U.S.has four basic forms of business organization:2-5The Business EnvironmentuOldest form of business organization.uuBusiness income is accounted for on your personal income tax form.Sole Proprietorship-A business form for which there is one owner.This single owner has unlimited liability for all debts of the firm.2-6Summary for Sole ProprietorshipAdvantagesuSimplicityuLow setup costuQuick setupuSingle tax filing on individual formDisadvantagesuUnlimited liabilityuHard to raise additional capitaluTransfer of ownership difficulties2-7The Business EnvironmentuuBusiness income is accounted for on each partners personal income tax form.Partnership-A business form in which two or more individuals act as owners.2-8Types of PartnershipsLimited Partnership -limited partners have liability limited to their capital contribution(investors only).At least one general partner is required and all general partners have unlimited liability.General Partnership -all partners have unlimited liability and are liable for all obligations of the partnership.2-9Summary for PartnershipAdvantagesAdvantagesuCan be simpleuLow setup cost,higher than sole proprietorshipuRelatively quick setupuLimited liability for limited partnersDisadvantagesDisadvantagesuUnlimited liability for the general partneruDifficult to raise additional capital,but easier than sole proprietorshipuTransfer of ownership difficulties2-10The Business EnvironmentuAn artificial entity that can own assets and incur liabilities.uuBusiness income is accounted for on the income tax form of the corporation.Corporation-A business form legally separate from its owners.2-11Summary for CorporationAdvantagesuLimited liabilityuEasy transfer of ownershipuUnlimited lifeuEasier to raise large quantities of capitalDisadvantagesuDouble taxationuMore difficult to establish uMore expensive to set up and maintain2-12The Business EnvironmentuuBusiness income is accounted for on each“members”individual income tax form.Limited Liability Companies-A business form that provides its owners(called“members”)with corporate-style limited personal liability and the federal-tax treatment of a partnership.2-13Limited Liability Company(LLC)uLimited liabilityuCentralized managementuUnlimited lifeuTransfer of ownership without other owners prior consentGenerally,an LLC will possess only the first two of the following four standard corporation characteristics2-14Summary for LLCAdvantagesAdvantagesuLimited liabilityuEliminates double taxationuNo restriction on number or type of ownersuEasier to raise additional capitalDisadvantagesDisadvantagesuLimited life(generally)uTransfer of ownership difficulties(generally)2-15Corporate Income Taxes2-16Income Tax ExampleLisa Miller of Basket Wonders(BW)is calculating the income tax liability,marginal tax rate,and average tax rate for the fiscal year ending December 31.BWs corporate taxable income for this fiscal year was$250,000.2-17Income Tax ExampleMarginal tax rate=39%Average tax rate =$80,750/$250,000=32.3%Income tax liability =$22,250+.39 x($250,000-$100,000)=$22,250+$58,500 =$80,7502-18DepreciationuGenerally,profitable firms prefer to use an accelerated method for tax reporting purposes.Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes,tax purposes,or both.2-19Common Types of Depreciationu Straight-line(SL)u Accelerated TypesuDouble Declining Balance(DDB)uModified Accelerated Cost Recovery System(MACRS)2-20Depreciation ExampleLisa Miller of Basket Wonders(BW)is calculating the depreciation on a machine with a depreciable basis of$100,000,a 6-year useful life,and a 5-year property class life.She calculates the annual depreciation charges using MACRS.Note ignore“bonus”depreciation discussed in 2-252-21MACRS ExampleuAssets are depreciated based on one of eight different property classes.uGenerally,the half-year convention is used.uDepreciation in any particular year is the maximum of DDB or straight-line.A switch in depreciation methods is made from DDB to SL during the life of the asset.2-22MACRS Example2-23MACRS Schedule2-24Jobs and Growth Tax Relief Reconciliation Act of 2019Increase&Extension of Bonus DepreciationIncrease&Extension of Bonus Depreciation Increases a limited and additional temporary depreciation deduction of 50%in the first year-subject to stipulations.Designed to enhance capital investment by businesses.2-25Jobs and Growth Tax Relief Reconciliation Act of 2019Increase&Extension of Bonus DepreciationIncrease&Extension of Bonus Depreciation ExampleExample:$200,000 machine under 5-year MACRS property class.Bonus=50%of$200K=$100K.Remaining$100K($200K-$100K bonus)at 20%rate based on MACRS is$20K.Result is$120K($100K+$20K)depreciation charge in the first year.Set to expire soon,so will ignore in subsequent problems(note ignored in slide 2-20)2-26Other Tax IssuesQuarterly Tax Payments require corporations to pay 25%of their estimated annual tax liability on the 15th of April,June,September,and December.Alternative Minimum Tax is a special tax which equals 20%of alternative minimum taxable income(generally not equal to taxable income).Corporations pay the maximum of AMT or regular tax liability.2-27Interest DeductibilityInterest Expense is the interest paid on outstanding debt and is tax deductible.Cash Dividend is the cash distribution of earnings to shareholders and is not a tax deductible expense.The after-tax cost of debt is:(Interest Expense)X(1-Tax Rate)Thus,debt financing has a tax advantage!2-28Handling Corporate Losses and GainsuLosses are generally carried back first and then forward starting with the earliest year with operating gains.uCorporations that sustain a net operating loss can carry that loss back(Carryback)2 years and forward(Carryforward)20 years to offset operating gains in those years.2-29Corporate Losses and Gains ExampleLisa Miller is examining the impact of an operating loss at Basket Wonders(BW)in 2019.The following time line shows operating income and losses.What impact does the 2019 loss have on BW?-$500,000-$500,000$100,000$100,000$150,000$150,000$150,000$150,00020192019201920192-30Corporate Losses and Gains ExampleThe loss can offset the gain in each of the years 2019 and 2019.The remaining$250,000$250,000 can be carried forward to 2019 or beyond.Impact:Tax refund for federal taxes paid in 2019 and 2019.-$500,000-$500,000$100,000$100,000$150,000$150,000$150,000$150,0002019201920192019-$150,000-$150,000-$100,000-$100,000$250,000$250,000$150,000$150,0000 00 0-$250,000-$250,0002-31Corporate Capital Gains/LossesuOften historically,capital gains income has received more favorable U.S.tax treatment than operating income.uGenerally,the sale of a“capital asset”(as defined by the IRS)generates a capital gain(asset sells for more than original cost)or capital loss(asset sells for less than original cost).2-32Corporate Capital Gains/LossesuuCapital losses are deductible only against capital gains.uCurrently,capital gains are taxed at ordinary income tax rates for corporations,or a maximum 35%.2-33Personal Income TaxesuThe U.S.has a progressive tax structure with four tax brackets of 10%,15%,25%,28%,33%,and 35%.uPersonal income taxes are determined by taxable income,filing status,and various credits.uResult is that low income individuals pay no federal tax and others may fluctuate between the marginal rates.2-34Financial EnvironmentuBusinesses interact continually with the financial markets.uuFinancial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.uThe purpose of financial markets is to efficiently allocate savings to ultimate users.2-35Flow of Funds in the EconomyINVESTMENT SECTORFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKET2-36Flow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETINVESTMENTINVESTMENTSECTORSECTORBusinessesGovernmentHouseholdsINVESTMENT SECTORINVESTMENT SECTOR2-37Flow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSAVINGSSAVINGSSECTORSECTORHouseholdsBusinessesGovernmentINVESTMENT SECTOR2-38Flow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSFINANCIAL BROKERSSECONDARY MARKETFINANCIALFINANCIALBROKERSBROKERSInvestment BankersMortgage BankersINVESTMENT SECTOR2-39Flow of Funds in the EconomyFINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETFINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIESCommercial BanksSavings InstitutionsInsurance Cos.Pension FundsFinance CompaniesMutual FundsINVESTMENT SECTOR2-40Flow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSECONDARY MARKETSECONDARYSECONDARYMARKETMARKETSecurityExchangesOTCMarketINVESTMENT SECTOR2-41Allocation of FundsuIn a rational world,the highest expected returns will be offered only by those economic units with the most promising investment opportunities.uuResult:Savings tend to be allocated to the most efficient uses.uFunds will flow to economic units that are willing to provide the greatest expected return(holding risk constant).2-42Risk-Expected Return ProfileRISKEXPECTED RETURN(%)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 Stocks2-43What Influences Security Expected Returns?uuMarketability is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession.uuDefault Risk is the failure to meet the terms of a contract.2-44Ratings by Investment Agencies on Default RiskInvestment grade Investment grade represents the top four categories.Below investment grade represents all other categories.2-45What Influences Expected Security Returns?uuTaxability considers the expected tax consequences of the security.uuMaturity is concerned with the life of the security;the amount of time before the principal amount of a security becomes due.2-46Term Structure of Interest RatesA yield curve is a graph of the relationship between yields and term to maturity for particular securities.Upward Sloping Yield CurveUpward Sloping Yield CurveDownward Sloping Yield Curve0 2 4 6 8 10YIELD(%)0 5 10 15 20 25 30(Usual)(Unusual)YEARS TO MATURITY2-47What Influences Expected Security Returns?uuInflation is a rise in the average level of prices of goods and services.The greater inflation expectations,then the greater the expected return.uuEmbedded Options provide the opportunity to change specific attributes of the security.
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