Chapter 2 The Business Tax and Financial Environments

Chapter 2 The Business, Tax, and Financial Environments

After studying Chapter 2, you should be able to: 1. 2. 3. 4. 5. 6. 7. Describe the four basic forms of business organization in the United States -- and the advantages and disadvantages of each. Understand how to calculate a corporation's taxable income and how to determine the corporate tax rate - both average and marginal. Understand various methods of depreciation. Understand why acquiring assets through the use of debt financing offers a tax advantage over both common and preferred stock financing. Describe the purpose and make up of financial markets. Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a security’s default risk. Understand what is meant by the term “term structure of interest rates” and relate it to a “yield curve. ”

The Business, Tax, and Financial Environments u The Business Environment u The Tax Environment u The Financial Environment

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

The Business Environment Sole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm. u Oldest form of business organization. u Business income is accounted for on your personal income tax form

Summary for Sole Proprietorship Advantages Disadvantages u Simplicity u Unlimited u Low u Hard setup cost u Quick u Single setup tax filing on individual form liability to raise additional capital u Transfer of ownership difficulties

The Business Environment Partnership -- A business form in which two or more individuals act as owners. u. Business income is accounted for on each partner’s personal income tax form

Types of Partnerships General Partnership -- all partners have unlimited liability and are liable for all obligations of the 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.

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

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

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

The Business Environment Limited Liability Companies -- A business form that provides its owners (called “members”) with corporatestyle limited personal liability and the federal-tax treatment of a partnership. u Business income is accounted for on each “member’s” individual income tax form

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

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

Tax Environment u. Corporate u. Personal Income Taxes Corporate Income Taxes u Corporate taxable income is found by deducting allowable expenses, including depreciation and interest from revenues

Corporate Income Taxes

Income Tax Example of ABC Company uincome tax liability umarginal tax rate u. Average tax rate ABC Company’s taxable income was $250, 000.

Income Tax Example Income tax liability = $22, 250 +. 39 x ($250, 000 - $100, 000) $100, 000 = $22, 250 + $58, 500 = $80, 750 Marginal tax rate = 39% Average tax rate = $80, 750 / $250, 000 = 32. 3%

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. Generally, profitable firms prefer to use an accelerated method for tax reporting purposes.

Common Types of Depreciation u Straight-line Method(SLM) u Accelerated Types u Double Declining Balance (DDB) u Modified Accelerated Cost Recovery System (MACRS)

Depreciation Example Cost of Machine $100, 000 Useful Life 6 -year Property Class 5 -year calculate the annual depreciation charges using MACRS

MACRS Example u For the 3, 5, 7, and 10 years property classes, the DDB method of depreciation is used. u This method then switches to straight-line depreciation for the remaining undepreciated book value in the first year when the straight-line method yields equal or greater deduction than the declining-balance method. u Assets in the 15 and 20 year classes are depreciated using the 150 percent-delining method, again switching to straight-line at the optimal time u The straight-line method must be used for real estate. u The half-year convention is applied u The half-year of depreciation in the year an asset is sold or retired from service. u If property is held for longer than its recovery period, a half year of depreciation is allowed for the year following the end of the recovery period.

MACRS Example

MACRS Schedule

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

Dividend Income u Any interest received by the corporation is included as ordinary income u Only 30 percent of dividend income is included as ordinary income Dividend Income Before Tax amount Less exemption $10, 000 70% Taxable Amount 7, 000 $3, 000 Suppose tax rate is 35%, then tax amount is $3000 x. 35 = 1050 Without exemption tax amount is = 3500 $10, 000 x. 35

Carryback and Carry Forward of Losses u Corporations that sustain a net operating loss can carry that loss back (Carryback) 2 years and forward (Carryforward) Carryforward 20 years to offset operating gains in those years. u Losses are generally carried back first and then forward starting with the earliest year with operating gains.

Corporate Losses and Gains Example Impact of an operating loss of $500, 000 at ABC Company in 2007. The following time line shows operating income and losses. What impact does the 2007 loss have on ABC? 2004 2005 2006 2007 $150, 000 $100, 000 -$500, 000

Corporate Losses Example The loss can offset against the profit of years 2005 and 2006. The remaining $250, 000 can be carried forward to 2008 or beyond. Impact: Tax refund for income taxes paid in 2005 and 2006. 2004 2005 2006 2007 $150, 000 -$150, 000 0 $100, 000 -$500, 000 $250, 000 -$250, 000 $150, 000 0

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

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

Financial Environment u All businesses operate within the financial system No need for financial assets and markets Saving = Investment u Financial System consist of number of institutions and markets u The purpose of financial markets is to allocate savings efficiently to ultimate users.

Financial Markets Financial markets are divided into two parts: u. Money Market u. Capital Market Money Market is concerned with buying and selling of short-term government and corporate debt securities Capital Market deals with relatively with longterm debt and equity instruments

Financial Markets Primary Market A primary market is a new issue market Secondary Market Secondary market deals with buying and selling of existing securities Example of Car market Kinds of Secondary Market u Security u OTC exchanges (Over the counter market) --- Deals with stock and bonds not listed on an exchange.

Allocation of Funds u Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant). 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: Savings tend to be allocated to the most efficient uses.

EXPECTED RETURN (%) Risk-Expected Return Profile Speculative Common Stocks Conservative Common Stocks Preferred Stocks Medium-grade Corporate Bonds Investment-grade Corporate Bonds Long-term Government Bonds Prime-grade Commercial Paper U. S. Treasury Bills (risk-free securities) RISK

What Influences Security Expected Returns? 1. Default Risk 2. Marketability/Liquidity 3. Maturity 4. Taxability 5. Option Features 6. Inflation 7. Behavior of Yields on Corporate Securities

What Influences Security Expected Returns? u Default Risk is the failure to meet the terms of a contract. u. Default risk is judged through rating agencies u. Moody, u In Standard & Poor’s Pakistan, rating agency is PACRA --Pakistan Credit Rating Agency

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

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

Yield Curve 0 2 4 6 8 10 YIELD (%) Term Structure of Interest Rates Upward Sloping Yield Curve (Usual) Downward Sloping Yield Curve (Unusual) 0 5 10 15 20 25 30 YEARS TO MATURITY A yield curve is a graph of the relationship between yields and term to maturity for particular securities.

What Influences Expected Security Returns? u Options provide the opportunity to change specific attributes of the security. 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 Behavior of Yields on Corporate Securities Supply and demand of securities can also influence the yield of securities