Bài giảng Financial Management - Chapter 2: The Business, Tax, and Financial Environments

Chapter 2The Business, Tax, and Financial EnvironmentsAfter studying Chapter 2, you should be able to: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 EnvironmentsThe Business EnvironmentThe Tax EnvironmentThe Financial EnvironmentThe Business EnvironmentSole ProprietorshipsPartnerships (general and limited)CorporationsLimited liability companiesThe US has four basic forms of business organization:The Business EnvironmentOldest form of business organization.Business 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.Summary for Sole ProprietorshipAdvantagesSimplicityLow setup costQuick setupSingle tax filing on individual formDisadvantagesUnlimited liabilityHard to raise additional capitalTransfer of ownership difficultiesThe Business EnvironmentBusiness income is accounted for on each partner’s personal income tax form.Partnership – A business form in which two or more individuals act as owners.Types 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.Summary for PartnershipAdvantagesCan be simpleLow setup cost, higher than sole proprietorshipRelatively quick setupLimited liability for limited partnersDisadvantagesUnlimited liability for the general partnerDifficult to raise additional capital, but easier than sole proprietorshipTransfer of ownership difficultiesThe Business EnvironmentAn artificial entity that can own assets and incur liabilities.Business income is accounted for on the income tax form of the corporation.Corporation – A business form legally separate from its owners.Summary for CorporationAdvantagesLimited liabilityEasy transfer of ownershipUnlimited lifeEasier to raise large quantities of capitalDisadvantagesDouble taxationMore difficult to establish More expensive to set up and maintainThe Business EnvironmentBusiness income is accounted for on each “member’s” 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.Limited Liability Company (LLC)Limited liabilityCentralized managementUnlimited lifeTransfer of ownership without other owners’ prior consentGenerally, an LLC will possess only the first two of the following four standard corporation characteristicsSummary for LLCAdvantagesLimited liabilityEliminates double taxationNo restriction on number or type of ownersEasier to raise additional capitalDisadvantagesLimited life (generally)Transfer of ownership difficulties (generally)Corporate Income TaxesIncome 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.BW’s corporate taxable income for this fiscal year was $250,000.Income Tax ExampleMarginal tax rate = 39%Average tax rate = $80,750 / $250,000 = 32.3%Income tax liability = $22,250 + 0.39 × ($250,000 – $100,000) = $22,250 + $58,500 = $80,750Also solve in Excel! – VW13E-02b.xlsxDepreciationGenerally, 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.Common Types of Depreciation Straight-line (SL) Accelerated TypesDouble Declining Balance (DDB)Modified Accelerated Cost Recovery System (MACRS)Depreciation 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 2–25]MACRS ExampleAssets are depreciated based on one of eight different property classes.Generally, the half-year convention is used.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.MACRS ExampleMACRS ScheduleEconomic Stimulus Act (ESA) of 2008Signed by President Bush, May 2008 – TemporaryAllowed additional first year depreciation equal to 50% of the original “adjusted (depreciable) basis”Eligible property with a life of 20 years or lessPurchased and placed in service in 2008Can opt “out” if desirable to businessEconomic Stimulus Act (ESA) of 2008 (Example)Assume purchase in service on July 8, 2008Example: Utilize half-year convention and 5–year MACRS property class for a $200,000 machine Bonus = 50% of $200,000 = $100,000. Remaining $100,000 ($200K – $100K bonus above) at 20% rate based on MACRS is $20,000. Result is $120,000 ($100,000 + $20,000) depreciation charge in the first year.Temporary (2008 only), so will ignore in subsequent examples as well as ignored in slide 2-20 example.Other 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.Interest 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!Handling Corporate Losses and GainsLosses are generally carried back first and then forward starting with the earliest year with operating gains.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.Corporate Losses and Gains ExampleLisa 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$150,0002007200620052004Corporate Losses and Gains ExampleThe 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$150,0002007200620052004–$150,000–$100,000 $250,000$150,00000–$250,000Corporate Capital Gains / LossesOften historically, capital gains income has received more favorable US tax treatment than operating income.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).Corporate Capital Gains / LossesCapital losses are deductible only against capital gains.Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%.Personal Income TaxesThe US has a progressive tax structure with four tax brackets of 10%, 15%, 25%, 28%, 33%, and 35%.The current maximum cash dividend (most) and capital gains tax rates is 15%.Personal income taxes are determined by taxable income, filing status, and various credits.Result is that low income individuals pay no federal tax and others may fluctuate between the marginal rates.Financial EnvironmentBusinesses interact continually with the 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.Flow of Funds in the EconomyINVESTMENT SECTORFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETFlow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETINVESTMENTSECTORBusinessesGovernmentHouseholdsINVESTMENT SECTORFlow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSAVINGSSECTORHouseholdsBusinessesGovernmentINVESTMENT SECTORFlow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETFINANCIALBROKERSInvestment BankersMortgage BankersINVESTMENT SECTORFlow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETFINANCIALINTERMEDIARIESCommercial BanksSavings InstitutionsInsurance Cos.Pension FundsFinance CompaniesMutual FundsINVESTMENT SECTORFlow of Funds in the EconomyFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETSECONDARYMARKETSecurityExchangesOTCMarketINVESTMENT SECTORAllocation of FundsIn a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities.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).Risk-Expected Return ProfileRISKEXPECTED RETURN (%)US Treasury Bills (risk-free securities)Prime-grade Commercial PaperLong-term Government BondsInvestment-grade Corporate BondsMedium-grade Corporate BondsPreferred StocksConservative Common StocksSpeculative Common StocksWhat Influences Security Expected Returns?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 is the failure to meet the terms of a contract.Ratings by Investment Agencies on Default RiskInvestment grade represents the top four categories.Below investment grade represents all other categories.What Influences Expected Security Returns?Taxability considers the expected tax consequences of the security.Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due.Term Structure of Interest RatesA yield curve is a graph of the relationship between yields and term to maturity for particular securities.Upward Sloping Yield CurveDownward Sloping Yield Curve0 2 4 6 8 10YIELD (%)0 5 10 15 20 25 30(Usual)(Unusual)YEARS TO MATURITYUS Treasury Yield Curve (4 / 16 / 2008)This yield curve is the relationship of US Treasuries effective April 16, 2008 (see VW13E–02.xlsx).What Influences Expected Security Returns?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 provide the opportunity to change specific attributes of the security.