CH 2

Chapter 2
The Business, Tax,

and Financial
Environments
2.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After studying Chapter 2,

you should be able to:
1.
2.
3.
4.
5.
6.
7.
2.2
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 securitys 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
The Business Environment
The Tax Environment
The Financial Environment
2.3
The Business
Environment
The US has four basic forms of
business organization:
Sole Proprietorships
Partnerships (general and limited)
Corporations
Limited liability companies
2.4
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.
Oldest form of business organization.
Business income is accounted for on

your personal income tax form.
form
2.5
Summary for
Sole Proprietorship
Disadvantages
Advantages
Simplicity
Unlimited liability
Low setup cost
Quick setup
Hard to raise
additional capital
Transfer of
ownership
difficulties
2.6
Single tax filing

on individual form
The Business
Environment
Partnership A business form in
which two or more individuals
act as owners.
2.7
Business income is accounted

for on each partners personal
income tax form.
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.
2.8
Summary for Partnership

Advantages
Disadvantages
Can be simple
Low setup cost, higher

than sole
proprietorship
Unlimited liability for

the general partner
Difficult to raise
additional capital, but
easier than sole
proprietorship
Transfer of ownership
difficulties
Relatively quick setup
Limited liability for

limited partners
2.9
The Business
Environment
Corporation A business form
legally separate from its owners.
An artificial entity that can own

assets and incur liabilities.
Business income is accounted for

on the income tax form of the
corporation.
corporation
2.10
Summary for Corporation

Advantages
Disadvantages
Limited liability
Double taxation
Easy transfer of
ownership
More difficult to
establish
Unlimited life
Easier to raise large

quantities of capital
More expensive
to set up and
maintain
2.11
The Business
Environment
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.
2.12
Business income is accounted for on

each members individual income tax
form.
form
Limited Liability
Company (LLC)
Generally, an LLC will possess only the
first two of the following four standard
corporation characteristics
Limited liability
Centralized management
Unlimited life
Transfer of ownership without other owners

prior consent
2.13
Summary for LLC

Advantages
2.14
Disadvantages
Limited liability
Eliminates double
taxation
Limited life
(generally)
Transfer of
ownership
difficulties
(generally)
No restriction on
number or type of
owners
Easier to raise
additional capital
Corporate Income Taxes
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2.15
Income Tax Example

Lisa Miller of Basket Wonders
(BW) is calculating the income tax
liability,
liability marginal tax rate,
rate and
average tax rate for the fiscal year
ending December 31.
BWs corporate taxable income for
this fiscal year was $250,000.
2.16
Income Tax Example

Income tax liability
= $22,250 + 0.39 ($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%
Also solve in Excel! VW13E-02b.xlsx
2.17
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.
2.18
Generally, profitable firms prefer to use

an accelerated method for tax reporting
purposes.
Common Types of
Depreciation
Straight-line (SL)
Accelerated Types
2.19
Double Declining Balance

(DDB)
Modified Accelerated Cost

Recovery System (MACRS)
Depreciation Example
Lisa Miller of Basket Wonders (BW) is
calculating the depreciation on a machine
with a depreciable basis of $100,000, a 6year useful life,
life and a 5-year property
class life.
She calculates the annual depreciation
charges using MACRS. [Note ignore
bonus depreciation discussed in 225]
2.20
MACRS Example
2.21
Assets 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.
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MACRS Example
2.22
MACRS Schedule
Recovery
Year
1
2
3
4
5
6
7
8
2.23
Property Class
3-Year
5-Year
33.33%
20.00%
44.45
32.00
14.81
19.20
7.41
11.52
11.52
5.76
7-Year
14.29%
24.49
17.49
12.49
8.93
8.92
8.93
4.46
Economic Stimulus Act

(ESA) of 2008
Signed by President Bush, May 2008 Temporary
Allowed additional first year depreciation

equal to 50% of the original adjusted
(depreciable) basis
Eligible property with a life of 20 years or

less
Purchased and placed in service in 2008
Can opt out if desirable to business
2.24
Economic Stimulus Act (ESA)

of 2008 (Example)
Assume purchase in service on July 8, 2008
Example:
Example
Utilize half-year convention and 5year 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.
2.25
Other Tax Issues

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.
Quarterly Tax Payments require
corporations to pay 25% of their
estimated annual tax liability on the 15th
of April, June, September, and December.
2.26
Interest Deductibility
Interest Expense is the interest paid on
outstanding debt and is tax deductible.
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
2.27
Handling Corporate
Losses and Gains
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.
Losses are generally carried back

first and then forward starting with
the earliest year with operating gains.
2.28
Corporate Losses
and Gains Example
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?
2.29
2004
2005
2006
2007
$150,000
$150,000
$100,000
$500,000
Corporate Losses
and Gains Example
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.
2004
2005
2006
2007
$150,000
$150,000
$150,000
0
$100,000
$100,000
$500,000
$250,000
$250,000
$150,000
2.30
Corporate Capital
Gains / Losses
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).
Often historically, capital gains income

has received more favorable US tax
treatment than operating income.
2.31
Corporate Capital
Gains / Losses
2.32
Currently, capital gains are taxed

at ordinary income tax rates for
corporations, or a maximum 35%.
Capital losses are deductible only

against capital gains.
gains
Personal Income Taxes
2.33
The US has a progressive tax structure with four

tax brackets of 10%, 15%,
15% 25%, 28%,
28% 33%,
33% and
35%.
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 Environment
2.34
Businesses 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 Economy
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
SAVINGS SECTOR
2.35
Flow of Funds
in the Economy
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
INVESTMENT
SECTOR
Businesses
Government
Households
SAVINGS SECTOR
2.36
Flow of Funds
in the Economy
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
SAVINGS
SECTOR
Households
Businesses
Government
SAVINGS SECTOR
2.37
Flow of Funds
in the Economy
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
FINANCIAL
BROKERS
Investment
Bankers
Mortgage
Bankers
SAVINGS SECTOR
2.38
Flow of Funds
in the Economy
FINANCIAL BROKERS
SECONDARY MARKET
SAVINGS SECTOR
2.39
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
FINANCIAL
INTERMEDIARIES
Commercial Banks
Savings Institutions
Insurance Cos.
Pension Funds
Finance Companies
Mutual Funds
Flow of Funds
in the Economy
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
INVESTMENT SECTOR
SECONDARY
MARKET
Security
Exchanges
OTC
Market
SAVINGS SECTOR
2.40
Allocation of Funds
2.41
Funds will flow to economic units that are

willing to provide the greatest expected
return (holding risk constant).
In 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.
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
US Treasury Bills (risk-free securities)
RISK
2.42
What Influences Security

Expected Returns?
2.43
Default Risk is the failure to meet

the terms of a contract.
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.
Ratings by Investment
Agencies on Default Risk
M
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Investment grade represents the top four categories.
Below investment grade represents all other categories.
2.44
What Influences Expected

Security Returns?
2.45
Maturity is concerned with the life

of the security; the amount of time
before the principal amount of a
security becomes due.
Taxability considers the expected

tax consequences of the security.
0 2 4 6 8 10
YIELD (%)
Term Structure of
Interest Rates
Upward Sloping Yield Curve
(Usual)
Downward Sloping Yield Curve

(Unusual)
0
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.
2.46
US Treasury Yield Curve

(4 / 16 / 2008)
This yield curve is the relationship of US Treasuries

effective April 16, 2008 (see VW13E02.xlsx).
2.47
What Influences Expected

Security Returns?
2.48
Embedded Options provide the

opportunity to change specific
attributes of the security.
Inflation is a rise in the average
level of prices of goods and
services. The greater inflation
expectations, then the greater the
expected return.

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Chapter 2

The Business, Tax,

After studying Chapter 2,

Describe the four basic forms of business organization in the

The Business, Tax, and

The Business Environment

The Tax Environment

The Financial Environment

Partnerships (general and limited)

Limited liability companies

Oldest form of business organization.

Business income is accounted for on

Low setup cost

Single tax filing

Business income is accounted

Limited Partnership limited partners

Summary for Partnership

Low setup cost, higher

Unlimited liability for

Relatively quick setup

Limited liability for

An artificial entity that can own

Business income is accounted for

Summary for Corporation

Easier to raise large

Business income is accounted for on

Transfer of ownership without other owners

Summary for LLC

Corporate Income Taxes

Income Tax Example

Income Tax Example

Marginal tax rate = 39%

Generally, profitable firms prefer to use

Double Declining Balance

Modified Accelerated Cost

Assets are depreciated based on one

Economic Stimulus Act

Allowed additional first year depreciation

Eligible property with a life of 20 years or

Purchased and placed in service in 2008

Can opt out if desirable to business

Economic Stimulus Act (ESA)

Utilize half-year convention and 5year MACRS

Other Tax Issues

Corporations that sustain a net

Losses are generally carried back

Generally, the sale of a capital asset

Often historically, capital gains income

Currently, capital gains are taxed

Capital losses are deductible only

Personal Income Taxes

The US has a progressive tax structure with four

Personal income taxes are determined by

Result is that low income individuals pay no

Businesses interact continually with

Funds will flow to economic units that are

EXPECTED RETURN (%)

What Influences Security

Default Risk is the failure to meet