2.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Chapter 2 The Business, Tax, and Financial Environments

2.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. After studying Chapter 2, you should be able to: 1. Describe the three basic forms of business organisation – and the advantages and disadvantages of each. 2. Understand various methods of depreciation. 3. Understand why acquiring assets through the use of debt financing offers a tax advantage over both common and preferred stock financing. 4. Describe the purpose and make up of financial markets. 5. Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a security’s default risk. 6. Understand what is meant by the term “term structure of interest rates” and relate it to a “yield curve.”

2.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Summary u Business environment u Types of business u Strengths and weaknesses u Financial environment u Financial institutions borrow and lend u Financial markets – new issues to the public, and secondary market u Private placement u Interest rates u Yield curve u What effects the interest rate

2.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business, Tax, and Financial Environments The Business Environment The Tax Environment The Financial Environment

2.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment Sole Proprietorships: A business owned by one person and operated for his or her own profit Partnerships: A business operated by two or more people together for a profit. (general and limited) Corporations: An intangible business entity created by law and is a separate ‘entity’ to its owners. There are other forms of business organisation, but we are not looking at them here. There are three basic forms of business organisation:

2.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment  Strengths of the basic legal forms of business organisation

2.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment u Weaknesses of the basic legal forms of business organisation

2.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment Oldest form of business organization. Business income personal income tax form Business income is accounted for on your personal income tax form. Sole Proprietorship Sole Proprietorship – A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.

2.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Summary for Sole Proprietorship Advantages Simplicity Low setup cost Quick setup Least regulated Owner keeps all profitsDisadvantages Unlimited liability Hard to raise additional capital Business entity limited to life of owner Can have limited access to outside funding for the business

2.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment Business income personal income tax form Business income is accounted for on each partner’s personal income tax form. Partnership Partnership – A business form in which two or more individuals act as owners.

2.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Types of Partnerships Limited Partnership Limited 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 General Partnership – all partners have unlimited liability and are liable for all obligations of the partnership.

2.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Summary for Partnership Advantages Can be simple Low setup cost, higher than sole proprietorship Relatively quick setup Limited liability for limited partnersDisadvantages Unlimited liability for the general partner Difficult to raise additional capital, but easier than sole proprietorship Transfer of ownership difficulties

2.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. The Business Environment An artificial entity that can own assets and incur liabilities. Business income income tax form of the corporation Business income is accounted for on the income tax form of the corporation. Corporation Corporation – A business form legally separate from its owners.

2.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Summary for Corporation Advantages Business is legal, separate entity from owners Limited liability Easy transfer of ownership Unlimited life Easier to raise large quantities of capital Disadvantages Double taxation of company profits More difficult to establish More expensive to set up and maintain

2.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Financial Environment u External funds can be sourced three ways: u Financial institutions u Financial markets u Private placement

2.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Financial Environment financial markets. Businesses interact continually with the financial markets. Financial Markets Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together. The purpose of financial markets is to efficiently allocate savings to ultimate users.

2.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Financial Environment u Financial Institutions: u Organisations that take the savings of individuals, businesses and governments and turn them into loans or investments with other organisations. u Many different types: u Banks, building societies, credit unions u Life insurance and finance companies u Superannuation and pension funds u Merchant banks u Specialised government funding agencies etc

2.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Flow of Funds in the Economy u Financial Intermediaries  u u Savers lend to lend to u Interest Interest u Savers Borrowers Banks Insurance Pension Funds Finance Coys

2.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Allocation of Funds In a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities. Result: Result: Savings tend to be allocated to the most efficient uses. Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant).

2.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Term Structure of Interest Rates A yield curve is a graph of the relationship between yields and term to maturity for particular securities. Upward Sloping Yield Curve Downward Sloping Yield Curve YIELD (%) (Usual) (Unusual) YEARS TO MATURITY

2.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Risk-Expected Return Profile RISK EXPECTED RETURN (%) US Treasury Bills (risk-free securities) Prime-grade Commercial Paper Long-term Government Bonds Investment-grade Corporate Bonds Medium-grade Corporate Bonds Preferred Stocks Conservative Common Stocks Speculative Common Stocks

2.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. What Influences Security Expected Returns? Marketability Marketability is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession. Default Risk Default Risk is the failure to meet the terms of a contract.

2.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. What Influences Expected Security Returns? Taxability Taxability considers the expected tax consequences of the security. Maturity Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due.

2.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. What Influences Expected Security Returns? Inflation Inflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return. Embedded Options Embedded Options provide the opportunity to change specific attributes of the security.