upload 6.ppt chapter2. Business tax and financial

Financial management I

1. 2.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 2Chapter 2
The Business, Tax, The Business, Tax,
and Financial and Financial
EnvironmentsEnvironments

2. 2.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After studying Chapter 2, After studying Chapter 2,
you should be able to: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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business, Tax, and The Business, Tax, and
Financial EnvironmentsFinancial Environments
•The Business Environment
•The Tax Environment
•The Financial Environment

4. 2.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business The Business
EnvironmentEnvironment
•Sole Proprietorships
•Partnerships (general and limited)
•Corporations
•Limited liability companies
The US has four basic forms of The US has four basic forms of
business organization:business organization:

5. 2.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business The Business
EnvironmentEnvironment
•Oldest form of business organization.
•Business income Business income is accounted for on
your personalpersonal income tax formincome tax form.
Sole ProprietorshipSole Proprietorship – A business
form for which there is one owner.
This single owner has unlimited
liability for all debts of the firm.

6. 2.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business The Business
EnvironmentEnvironment
•Business income Business income is accounted
for on each partner’s personalpersonal
income tax formincome tax form.
PartnershipPartnership – A business form in
which two or more individuals
act as owners.

7. 2.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Types of PartnershipsTypes 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.

8. 2.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business The Business
EnvironmentEnvironment
•An artificial entity that can own
assets and incur liabilities.
•Business income Business income is accounted for
on the income tax form of the income tax form of the
corporationcorporation.
CorporationCorporation – A business form
legally separate from its owners.

9. 2.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Business The Business
EnvironmentEnvironment
•Business income Business income is accounted for on
each “member’s” individual income tax individual income tax
formform.
Limited Liability CompaniesLimited 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.

10. 2.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corp. Taxable Income Tax
At Least But < Rate Tax Calculation
$ 0 $ 50,000 15% 0.15x(Inc > 0)
50,000 75,000 25% $ 7,500 + 0.25x(Inc > 50,000)
75,000 100,000 34% 13,750 + 0.34x(Inc > 75,000)
100,000 335,000 39% 22,250 + 0.39x(Inc > 100,000)
335,000 10,000,000 34% 113,900 + 0.34x(Inc > 335,000)
10,000,000 15,000,000 35% 3,400,000 + 0.35x(Inc > 10,000,000)
15,000,000 18,333,333 38% 5,150,000 + 0.38x(Inc > 15,000,000)
18,333,333 35% 6,416,667 + 0.35x(Inc > 18,333,333)


Corporate Income TaxesCorporate Income Taxes

11. 2.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
DepreciationDepreciation
•Generally, profitable firms prefer to use
an accelerated method for tax reporting
purposes.
DepreciationDepreciation represents the
systematic allocation of the cost of
a capital asset over a period of time
for financial reporting purposes, tax
purposes, or both.

12. 2.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Common Types of Common Types of
DepreciationDepreciation
• Straight-line (Straight-line (SLSL))
• Accelerated TypesAccelerated Types
•Double Declining Balance
(DDB)
•Modified Accelerated Cost
Recovery System (MACRS)

13. 2.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Depreciation ExampleDepreciation Example
Lisa Miller of Basket Wonders (BW) is
calculating the depreciation on a machine
with a depreciable basis of $100,000, a 6-6-
year useful lifeyear 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]

14. 2.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
MACRS ScheduleMACRS Schedule
Recovery Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46

15. 2.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Interest DeductibilityInterest Deductibility
Interest ExpenseInterest Expense is the interest paid on
outstanding debt and is tax deductibletax deductible.
Cash Dividend is the cash distribution of
earnings to shareholders and is not a tax
deductible expense.
The after-tax cost of debt after-tax cost of debt is: (Interest
Expense) X ( 1 – Tax Rate)
Thus, debt financing has a tax advantagetax advantage!

16. 2.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Handling Corporate Handling Corporate
Losses and GainsLosses and Gains
•Losses 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
(CarryforwardCarryforward) 20 years 20 years to offset
operating gains in those years.

17. 2.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial EnvironmentFinancial Environment
•Businesses interact continually with
the financial markets.financial markets.
•Financial MarketsFinancial 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.

18. 2.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial MarketsFinancial Markets
Financial Markets are the
meeting place for people,
corporations, and institutions to
buy or sell securities.

19. 2.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Kinds of Financial Kinds of Financial
MarketsMarkets
Public and corporate financial
markets.
Domestic and international
markets.
Money and capital markets.

20. 2.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Money MarketsMoney Markets
Deals with short-term securities
that have a life of one year or less.
Securities in these markets
include:
1. Commercial paper. It is a debt
instrument sold by Corporations
or Banks.

21. 2.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Money MarketsMoney Markets
2. Certificates of Deposit. It is a debt
instrument with a maturities of less
than 12 months sold by banks.
3. Banker’s Acceptance. It is a time
draft drawn on and accepted by
bank for import-export
transactions.

22. 2.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Money MarketsMoney Markets
4. Treasury Bills. It is short-term
securities with maturities of one
year or less issued at discount
from face value.

23. 2.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital MarketsCapital Markets
Deals with securities that have a life of
more than one year. Long-term
markets.
Securities include:
1.Common Stock 2. Preferred Stock
3. Corporate & Government Bonds

24. 2.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Kinds of Financial MarketsKinds of Financial Markets
1. Primary Market. Where new issued
securities are sold.
2. Secondary Market (Stock -
Exchange Market). It is organized
marketplace where securities are
bought and sold amongst the
investors. Prices of securities keep
changing continually in this market.

25. 2.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Kind of InvestorsKind of Investors
1. Long-term Investors
2. Speculators
3. Gamblers

26. 2.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Securities AnalysisSecurities Analysis
1. Fundamental Analysis
2. Strategic Analysis
3. Technical Analysis

27. 2.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Securities ValueSecurities Value
1. Par Value (Subscription Value)
2. Book value (Accounting Value)
3. Market Value (Price of stock)
4. Real Value (Good Well)

28. 2.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
INVESTMENT SECTOR
F
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S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET

29. 2.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
F
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SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
INVESTMENTINVESTMENT
SECTORSECTOR
Businesses
Government
Households
INVESTMENT INVESTMENT
SECTORSECTOR

30. 2.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
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SAVINGS SECTORSAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SAVINGSSAVINGS
SECTORSECTOR
Households
Businesses
Government
INVESTMENT
SECTOR

31. 2.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
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SAVINGS SECTOR
FINANCIAL BROKERSFINANCIAL BROKERS
SECONDARY MARKET
FINANCIALFINANCIAL
BROKERSBROKERS
Investment
Bankers
Mortgage
Bankers
INVESTMENT
SECTOR

32. 2.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
F
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SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIALFINANCIAL
INTERMEDIARIESINTERMEDIARIES
Commercial Banks
Savings Institutions
Insurance Cos.
Pension Funds
Finance Companies
Mutual Funds
INVESTMENT
SECTOR

33. 2.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Flow of Funds Flow of Funds
in the Economyin the Economy
F
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SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKETSECONDARY MARKET
SECONDARYSECONDARY
MARKETMARKET
Security
Exchanges
OTC
Market
INVESTMENT
SECTOR

34. 2.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Allocation of FundsAllocation of Funds
•In a rational world, the highest expected
returns will be offered only by those
economic units with the most promising
investment opportunities.
•ResultResult: : 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).

35. 2.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk-Expected Risk-Expected
Return ProfileReturn Profile
RISK
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X
P
E
C
T
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D

R
E
T
U
R
N

(
%
)
US Treasury Bills (risk-free securities)US Treasury Bills (risk-free securities)
Prime-grade Commercial PaperPrime-grade Commercial Paper
Long-term Government Bonds
Investment-grade Corporate Bonds
Medium-grade Corporate Bonds
Preferred Stocks
Conservative Common Stocks
Speculative Common Stocks

36. 2.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What Influences Security What Influences Security
Expected Returns?Expected Returns?
•MarketabilityMarketability 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 RiskDefault Risk is the failure to meet
the terms of a contract.

37. 2.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Ratings by Investment Ratings by Investment
Agencies on Default RiskAgencies on Default Risk
MOODY’S INV SERVICE STANDARD & POOR’S
Aaa Best Quality AAA Highest Grade
Aa High Quality AA High Grade
A Upper Med Grade A Higher Med Grade
Baa Medium Grade BBB Medium Grade
Ba Possess Speculative
Elements
BB Speculative

C Lowest Grade D In Payment Default


Investment grade Investment grade represents the top four categories.
Below investment grade represents all other categories.

38. 2.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What Influences Expected What Influences Expected
Security Returns?Security Returns?
•TaxabilityTaxability considers the expected
tax consequences of the security.
•MaturityMaturity is concerned with the life
of the security; the amount of time
before the principal amount of a
security becomes due.

39. 2.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Term Structure of Term Structure of
Interest RatesInterest Rates
A yield curve is a graph of the relationship between
yields and term to maturity for particular securities.
Upward Sloping Yield CurveUpward Sloping Yield Curve
Downward Sloping Yield Curve
0



2



4



6



8



1
0
Y
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(
%
)
0 5 10 15 20 25 30
(Usual)
(Unusual)
YEARS TO MATURITY