1. 2-1 Chapter 2 The Business, Tax, and Financial Environments © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

2. 2-2 After 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 corporation's 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 security’s default risk. 7. Understand what is meant by the term “term structure of interest rates” and relate it to a “yield curve.”

3. 2-3 The Business, Tax, and Financial Environments u The Business Environment u The Tax Environment u The Financial Environment

4. 2-4 The Business Environment u Sole Proprietorships u Partnerships (general and limited) u Corporations u Limited liability companies The U.S. has four basic forms of business organization:

5. 2-5 The Business Environment u Oldest form of business organization. u Business income personal income tax form u 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.

6. 2-6 Summary for Sole Proprietorship Advantages u Simplicity u Low setup cost u Quick setup u Single tax filing on individual formDisadvantages u Unlimited liability u Hard to raise additional capital u Transfer of ownership difficulties

7. 2-7 The Business Environment u Business income personal income tax form u 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.

8. 2-8 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.

9. 2-9 Summary for Partnership Advantages u Can be simple u Low setup cost, higher than sole proprietorship u Relatively quick setup u Limited liability for limited partnersDisadvantages u Unlimited liability for the general partner u Difficult to raise additional capital, but easier than sole proprietorship u Transfer of ownership difficulties

10. 2-10 The Business Environment u An artificial entity that can own assets and incur liabilities. u Business income income tax form of the corporation u Business income is accounted for on the income tax form of the corporation. Corporation Corporation -- A business form legally separate from its owners.

11. 2-11 Summary for Corporation Advantages u Limited liability u Easy transfer of ownership u Unlimited life u Easier to raise large quantities of capitalDisadvantages u Double taxation u More difficult to establish u More expensive to set up and maintain

12. 2-12 The Business Environment u Business income individual income tax form u Business income is accounted for on each “member’s” individual income tax form. Limited Liability Companies 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.

13. 2-13 Limited Liability Company (LLC) u Limited liability u Centralized management u Unlimited life u Transfer of ownership without other owners’ prior consent Generally, an LLC will possess only the first two of the following four standard corporation characteristics

14. 2-14 Summary for LLC Advantages u Limited liability u Eliminates double taxation u No restriction on number or type of owners u Easier to raise additional capitalDisadvantages u Limited life (generally) u Transfer of ownership difficulties (generally)

15. 2-15 Corporate Income Taxes

16. 2-16 Income Tax Example income tax liabilitymarginal tax rate average tax rate Lisa 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. BW’s corporate taxable income for this fiscal year was $250,000.

17. 2-17 Income Tax Example Marginal tax rate 39% Marginal tax rate = 39% Average tax rate 32.3% Average tax rate = $80,750 / $250,000 = 32.3% $100,000 Income tax liability = $22,250 +.39 x ($250,000 - $100,000) = $22,250 + $58,500 = $80,750

18. 2-18 Depreciation u Generally, profitable firms prefer to use an accelerated method for tax reporting purposes. Depreciation 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.

19. 2-19 Common Types of Depreciation Straight-line (SL) u Straight-line (SL) Accelerated Types u Accelerated Types u Double Declining Balance (DDB) u Modified Accelerated Cost Recovery System (MACRS)

20. 2-20 Depreciation Example 6- year useful life Lisa 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 2-25]

21. 2-21 MACRS Example u Assets are depreciated based on one of eight different property classes. u Generally, the half-year convention is used. u Depreciation 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.

22. 2-22 MACRS Example

23. 2-23 MACRS Schedule

24. 2-24 Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & 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.

25. 2-25 Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & 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)

26. 2-26 Other Tax Issues Quarterly Tax Payments Quarterly 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 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.

27. 2-27 Interest Deductibility Interest Expense tax deductible Interest 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. after-tax cost of debt The after-tax cost of debt is: (Interest Expense) X ( 1 - Tax Rate) tax advantage Thus, debt financing has a tax advantage!

28. 2-28 Handling Corporate Losses and Gains u Losses are generally carried back first and then forward starting with the earliest year with operating gains. Carryforward20 years u Corporations 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.

29. 2-29 Corporate Losses and Gains Example What impact does the 2007 loss have on BW? Lisa Miller is examining the impact of an operating loss at Basket Wonders (BW) in 2003. The following time line shows operating income and losses. What impact does the 2007 loss have on BW? -$500,000 $100,000 $150,000 $150,000 2007200620052004

30. 2-30 Corporate Losses and Gains Example $250,000 The loss can offset the gain in each of the years 2005 and 2006. The remaining $250,000 can be carried forward to 2008 or beyond. Impact: Tax refund for federal taxes paid in 2005 and 2006. -$500,000 $100,000 $150,000 $150,000 2007200620052004 -$150,000-$100,000$250,000 $150,000 0 0-$250,000

31. 2-31 Corporate Capital Gains / Losses u Often historically, capital gains income has received more favorable U.S. tax treatment than operating income. capital gain capital loss u Generally, 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).

32. 2-32 Corporate Capital Gains / Losses u Capital losses capital gains u Capital losses are deductible only against capital gains. capital gains u Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%.

33. 2-33 Personal Income Taxes progressive tax structure 10%, 15%28% 33% 35% u The U.S. has a progressive tax structure with four tax brackets of 10%, 15%, 25%, 28%, 33%, and 35%. u Personal income taxes are determined by taxable income, filing status, and various credits. u Result is that low income individuals pay no federal tax and others may fluctuate between the marginal rates.

34. 2-34 Financial Environment financial markets. u Businesses interact continually with the financial markets. u Financial Markets u Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together. u The purpose of financial markets is to efficiently allocate savings to ultimate users.

35. 2-35 Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET

36. 2-36 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET INVESTMENTSECTOR Businesses Government Households INVESTMENT SECTOR

37. 2-37 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET SAVINGSSECTOR Households Businesses Government INVESTMENT SECTOR

38. 2-38 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET FINANCIALBROKERS Investment Bankers Mortgage Bankers INVESTMENT SECTOR

39. 2-39 Flow of Funds in the Economy FINANCIALINTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET FINANCIALINTERMEDIARIES Commercial Banks Savings Institutions Insurance Cos. Pension Funds Finance Companies Mutual Funds INVESTMENT SECTOR

40. 2-40 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET SECONDARYMARKET Security Exchanges OTC Market INVESTMENT SECTOR

41. 2-41 Allocation of Funds u In a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities. u Result: u Result: Savings tend to be allocated to the most efficient uses. u Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant).

42. 2-42 Risk-Expected Return Profile RISK EXPECTED RETURN (%) U.S. 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

43. 2-43 What Influences Security Expected Returns? u Marketability u 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. u Default Risk u Default Risk is the failure to meet the terms of a contract.

44. 2-44 Ratings by Investment Agencies on Default Risk Investment grade Investment grade represents the top four categories. Below investment grade represents all other categories.

45. 2-45 What Influences Expected Security Returns? u Taxability u Taxability considers the expected tax consequences of the security. u Maturity u Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due.

46. 2-46 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 0 2 4 6 8 10 YIELD (%) 0 5 10 15 20 25 30 (Usual) (Unusual) YEARS TO MATURITY

47. 2-47 What Influences Expected Security Returns? u Inflation u Inflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return. u Embedded Options u Embedded Options provide the opportunity to change specific attributes of the security.