Capital Structure

Capital Structure
Long-term financial management concerns
the way a firm finances its assets over
the long term.

The permanent, long-term sources of

financing that a company uses are
referred to collectively as the company’s
capital structure.
External Funds
• Long-term debt
• Preferred stock
• Common stock
Internal Funds
• Retained Earnings
Determining Capital Structure
• The future prospects of the company.
• The state of the equity market.
• The composition of the company’s assets.
• The amount of risk the company is willing to
accept. Debt sources are inherently riskier to the
firm than equity sources.
• The reputation of the issuer (the company issuing
the securities) and the interest rate it would need
to pay in order to be able to issue debt.
• The cost of each source of capital.
Bonds (Debt Securities)
Bonds are a means of financing in which a
company borrows money by selling debt
securities (bonds) to investors.

A bond issue represents a loan by the

bondholders (investors) to the issuing
company.
The Bond Information

BON D

P a r ( Fa c e ) Va lu e – $ 1 , 0 0 0 I n t e re s t Ra t e – 8 %

I s s u e D a t e – Ja n u a ry 1 , 2 0 X0

Ma t u rit y D a t e – De c e m b e r 3 1 , 2 0 X9

I n t e re s t – p a id s e m i- a n n u a lly , Ju n e 3 0 a n d D e c e m b e r 3 1
The Bond Cash Flows
1) Selling price of the bond received
2) Interest paid
3) Face value paid
The Bond Indenture
The legal contract is called the indenture
and it contains all the terms and conditions
of the contract: the interest rate, the stated
value, payment dates, maturity date, as
well as any:
• Restrictive covenants
• Call provision
• Putable
Bond Quotes
The price of a bond is quoted as its price
per $100 of par value.

A $1,000 par value bond is quoted at

103.25 means the bond’s price is
$103.25 per $100 of par value, or the
price is $1,032.50 for a $1,000 par value
bond.
Default Risk of a Bond
The buyer of a bond is a lender to the
issuer of the bond, and one of the main
risks the buyer takes is the risk that the
issuer will default on the bond obligation.
A default means that the issuer will not be
able to pay the interest due periodically
on the bond or the principal amount
when the bond is due, or both.
Benefits of Issuing Bonds
• The bond issuer has no loss of control or ownership.
• The total cost of the bonds is limited and known
because the interest rate that is used to calculate
the cash paid for interest is constant throughout the
life of the bond.
• Interest paid on bonds is tax deductible as a
business expense.
• If the bonds are callable or can otherwise be retired
early, the company has the flexibility to retire the
bonds and eliminate the interest payment.
Limitations of Issuing Bonds
• Debt as a source of capital creates less flexibility for the
company than does equity.
• The issuing company assumes increased risk because
of the possibility of default on the debt.
• As the level of debt grows, the interest rate on the next
loan or bond and the return required by the debt
holders and shareholders will increase.
• The maturity of the debt will result in a large future
cash payout that will need to be made all at one time.
• The terms of the bond issue may include restrictive
terms and covenants that must be adhered to.
Stock (Equity Securities)
Shares in the company represent
ownership of the company.
• Common stock
• Preferred stock
Common Stock
Shareholders who own common stock are
the residual owners of the company.
Rights (and Expectations)
of Shareholders
• The right to vote.
• The right to receive dividends, if
common dividends are declared.
• The right to buy shares of a new issue
IF the shares have preemptive rights.
• The rights to share in the distribution
of residual assets if the company is
liquidated.
Benefits of Common Stock
• Common stock does not have a fixed periodic
payment (like bond interest) that must be made to
the holders.
• Shares do not mature and do not require a future
repayment of the principal.
• Common stock provides the firm with greater
flexibility in its financial structure because it does not
have an obligation to make interest payments or
repay principal.
• The issuance of shares brings additional capital into
the firm.
Limitations of Common Stock
• There is a limit to the number of shares a
company can issue.
• The cost of issuing stock may be higher than the
cost of issuing debt.
• Since common stock is the riskiest security from
an investor’s viewpoint, investors expect the
highest return on their equity investments.
• Unlike interest on bonds, distributions made in
the form of dividends are not a tax-deductible
business expense to the payer.
Preferred Stock
Preferred stock is a hybrid, or cross,
between common stock and bonds.
Similar to Bonds
• Preferred stockholders usually do not vote on issues at
the annual meeting.
• Preferred stock usually pays, or earns, a fixed annual
payment in the form of a dividend.
• Preferred shareholders have preference over common
shareholders in an asset distribution in a liquidation.
• Preferred stockholders generally receive dividends
before common stockholders.
• Often, preferred stocks are issued with bond-like
features such as callability, convertibility, having a
maturity date.
Similar to Common Stock
• Not paying preferred dividends during
times of financial distress does not breach
a contract and cannot result in bankruptcy
proceedings.
• Preferred dividends are paid after interest
and taxes.
• In the event of asset distribution in a
liquidation, preferred shareholders are
junior to bondholders and other creditors.
Benefits of Preferred Stock
• Since preferred shareholders have no
voting rights, the voting control of the
company is not diluted.
• In most cases, any unusually high profits
are maintained for the common
shareholders rather than needing to be
distributed as dividends to preferred
shareholders.
Limitations of Preferred Stock
Preferred dividends are not tax-deductible
as interest on debt would be.
Cost of Capital
Capital
Capital is the term used for the long-term
funding used by firms.

A firm’s capital is supplied by its creditors

(its lenders) and its owners (its
shareholders).
The Cost of Capital
A company’s overall cost of capital is the
return expected by investors on a portfolio
consisting of all the company’s outstanding
securities.

Total After-Tax Costs of Financing

Total Market Value of Financing
Another Perspective
Since the security represents the agreement
between the two parties, the required
return from the investor’s perspective is
equal to the cost of capital from the
company’s standpoint.
Therefore, a company’s cost of capital is the
average rate of return that investors
demand to invest in the company’s debt
and equity.
Calculating Cost of Capital
1. Calculate the costs of the individual
components of capital structure.
2. Assess the firm’s capital structure.
3. Calculate the WACC.
Example: A firm finances its business with 60% debt
and 40% common equity (no preferred stock). If the
after-tax cost of debt is 6.8% and the cost of common
equity is 12.4%, the firm’s WACC is calculated as
follows:
Cost of Capital = (6.8% × 0.6) + (12.4% × 0.4)
Debt Equity

= 4.08% + 4.96%
= 9.04%.
Example: TAM Corporation has the following
outstanding capital (book values):
Debt 1,000,000
Preferred Stock 300,000
Common Stock 57,800
Additional Paid-in Capital-Common Stock 492,200
Retained Earnings 1,200,000
Total Capital 3,050,000

The firm’s tax rate is 35%.

The debt consists of 1,000 bonds with a face value of 1,000 each.
They mature in 5 years and have a coupon rate of 4.09%, payable
semi-annually. They were sold 5 years ago at par and have a current
market value of 96, which means their market value is 96% of their
face value of 1,000,000, or 960,000. The current market interest rate
for bonds with the same term and similar risk characteristics is 5%.

The preferred stock consists of 12,000 shares of preferred stock

outstanding, par value 25 each, and a market value of 25.50 per
share. The annual dividend is 4% of the par value.

The common stock consists of 57,800 shares outstanding with a par

value of 1 each. The market value of the common stock is 30 per
share. The common stock dividend was 1.25 last year and is
expected to grow consistently by 4% annually.
Cost of Debt
Cost of Debt
The cost of debt is the interest rate to pay
(yield demanded by investors) adjusted
for taxes.

Because of this tax deductibility and their

inherently lower risk than equity
sources, bonds are generally the lowest
after-tax cost source of new financing.
Cost of Debt Formula
The formula to calculate the cost of debt is as
follows:
Cd = C (1 - t)
Where:
Cd = the after tax cost of debt
C = the cost of the debt before taxes using
current effective annual interest rate
t = the marginal tax rate
Changing Tax Rates
If the tax rate increases while the interest
rate remains the same, the cost of debt
will decrease.

The opposite is also true – a decrease in

the tax rate increases the cost of debt.
Example: The market rate of interest on TAM
Corporation’s bonds is 5%, and TAM’s tax rate is 35%.
Therefore, the after-tax cost of TAM’s debt is:
0.05 × (1 − 0.35)
0.0325 or 3.25%.
Cost of Preferred Stock
Cost of Preferred Stock
The cost of preferred stock is calculated in
much the same way as the cost of debt
because most preferred shares pay their
dividend in the form of some percentage
of the face (par) value of the shares.
Because preferred dividends are a
distribution of income, they are not tax
deductible.
Cost of Existing Preferred Stock

Annual Cash Flow Dividend per Share

Current Market Price of Preferred Stock
Example: The cost of TAM Corporation’s existing preferred stock is the
annual dividend divided by the current market value of the preferred
shares.
The annual dividend is 4% of the par value of 25, or 1.00 per share. The
market value of the preferred shares is 25.50 per share.
Therefore, the cost of the preferred stock is
1.00 ÷ 25.50
0.039, which is 3.9%.

The cost of the preferred stock can also be calculated on the basis of the
total outstanding stock. The annual dividend is 1.00 per share and 12,000
shares are outstanding, so the annual dividend on the outstanding shares
is 12,000. The market value of the preferred shares is 25.50 per share, so
the total market value outstanding is 25.50 × 12,000, or 306,000. Thus,
the cost of the preferred stock is 12,000 ÷ 306,000 = 0.039, or 3.9%.
Cost of New Preferred Stock
When issuing new shares, the firm will
incur flotation costs, which reduce the
proceeds from the sale of the securities.

Yearly Dividend (D)

Net Proceeds from Issuance (Pn)
Cost of Common Equity
Cost of Common Equity
A firm can raise common equity capital in
two main ways:
1. Retained earnings
2. New common equity
1. Cost of Retained Earnings
The cost of retained earnings to the
company is not a cash cost that is paid in
the form of dividends or interest. Rather, it
is the opportunity cost of the next best
investment that was not made by the
shareholders.
Investors’ Required Rate of Return
The cost of retained earnings is based
upon the risk of the firm and the investors’
required rate of return.
There are two different ways to calculate
the cost of retained earnings:
A. Dividend (Gordon) Growth model
B. Capital Asset Pricing Model (CAPM)
A. Dividend (Gordon) Growth Model
The dividend (Gordon) growth model uses
• dividends per share
• the expected growth rate
• the market price of the share
in order to estimate the cost of retained
earnings.
Dividend Growth Formula

D1
Cre = +G
P0
D1 = The next annual dividend to be paid
per share
P0 = Common stock price per share today
G = The annual expected % growth rate
in dividends
Example: TAM Corporation paid dividends on its common stock
last year equal to 1.25 per share, and the dividend is expected to
grow by 4% per year.
Therefore, the expected annual dividend on TAM’s common
stock next year is 1.25 × 1.04, or 1.30.
The market price of TAM’s common stock is 30 per share.
The cost of TAM Corporation’s retained earnings and existing
common equity is

($1.30 ÷ $30) + 0.04 = 0.0833 or 8.33%.

B. Capital Asset Pricing Model
Many companies pay little or no dividend
to their shareholders.

CAPM is frequently used to estimate the

cost of equity – either retained earnings
or new equity.
Capital Asset Pricing Model

R = RF + B (RM – RF)

Where:
RF = the risk-free rate
B = Beta
RM = the market rate of return
R = the cost of retained earnings
Example: Assume Company Y’s common stock has a beta of 0.90,
investors demand a market rate of return of approximately 8%, and
the risk-free rate is 1%. The required rate of return on Company Y’s
common stock is calculated as follows:
0.01 + [0.90 (0.08 – 0.01)] = 0.073 or 7.3%

Note that the calculated required rate of return for Company Y’s stock
is below the 8% market rate of return. This is because Company Y’s
beta (0.90) is less than 1.
If Company Y’s beta had been greater than 1, the investors’ required
return for the stock would have been higher than the market rate,
because the risk of this stock would be higher than the risk to the
market as a whole and in order to hold the investment, investors
would demand a higher risk premium than the risk premium for the
market as a whole.
Even though Company Y’s beta is less than 1, investors will still
require a risk premium to hold the stock, because the stock is still
more risky than a risk-free security.

The risk premium for Company Y’s common stock with a beta of
0.90 is calculated as 0.90(0.08 – 0.01), which equals 0.063 or
6.3%. This 6.3% is the risk premium that investors require in
addition to the risk-free rate of 1% in order to hold Company Y
common stock.

Note that when Company Y’s risk premium of 6.3% is added to

the risk-free rate of 1%, the result is the required rate of return on
Company Y’s common stock: 7.3%.
2. Cost of New Common Equity
The cost of new external common equity is
higher than the cost of retained earnings
because the process of registering and
selling the stock will cost the company
money.
New Common Equity Formula
D1
Cns = +G
Pn
D1 = The next annual dividend to be paid
per share
Pn = Net proceeds from the issuance
G = The annual expected % growth rate
in dividends
Assessing Capital Structure
and Calculating Weighted
Average Cost of Capital
Assessing Capital Structure
Must assess the firm’s capital structure to
determine the appropriate weighting (as
a percentage of total capital) to be
assigned to each component.

A firm’s capital structure is the mixture of

capital that it uses to finance its assets.
Example: TAM Corporation has the following
outstanding capital (book values):
Debt 1,000,000
Preferred Stock 300,000
Common Stock 57,800
Additional Paid-in Capital-Common Stock 492,200
Retained Earnings 1,200,000
Total Capital 3,050,000

The firm’s tax rate is 35%.

The debt consists of 1,000 bonds with a face value of 1,000
each. They mature in 5 years and have a coupon rate of 4.09%,
payable semi-annually. They were sold 5 years ago at par and
have a current market value of 96, which means their market
value is 96% of their face value of 1,000,000, or 960,000. The
current market interest rate for bonds with the same term and
similar risk characteristics is 5%.
The preferred stock consists of 12,000 shares of preferred stock
outstanding, par value 25 each, and a market value of 25.50 per
share. The annual dividend is 4% of the par value.
The common stock consists of 57,800 shares outstanding with a
par value of 1 each. The market value of the common stock is 30
per share. The common stock dividend was 1.25 last year and is
expected to grow consistently by 4% annually.
Market values of the capital and the proportion of total capital
represented by each are as follows:
Debt (96% of 1,000,000) 960,000 32.0%
Preferred Stock (25.50 × 12,000) 306,000 10.2%
Common Stock (30 × 57,800) 1,734,000 57.8%
Total Market Value of Capital 3,000,000
Calculating the WACC
The final step uses the proportion and cost
of each component of capital to find the
weighted average rate.
We have calculated the cost of each component as follows:
Debt (after-tax) 3.25%
Preferred stock 3.90%
Common stock 8.33%
Using the individual component costs we calculated and the
proportion of each type of capital to the total market value of the
capital as the weighting, the weighted average cost of capital is:
Proportion Cost x
Cost (Weighting) Weight
Debt 0.0325 x 0.320 = 0.0104
Preferred stock 0.0390 x 0.102 = 0.0040
Common stock 0.0833 x 0.578 = 0.0481
Weighted Average Cost of Capital is 0.0625 or 6.25%
Capital Budgeting
Capital Budgeting
Capital budgeting refers to a group of
methods used by a company to analyze
projects to invest in.

The objective is to select projects to

maximize the value of its equity and
shareholders’ wealth.
Stages in Capital Budgeting
1. Identification stage
2. Search stage
3. Information–acquisition stage
4. Selection stage
5. Financing stage
6. Implementation and control stage
Relevant Cash Flows
Relevant Cash Flows
Relevant revenues, costs or cash flows
are those revenues, costs or cash flows
that are different between possible
alternatives.
Expected Cash Flows
The cash flow amount that will be used in
the capital budgeting analysis for each
year is the expected cash flow, or the
weighted average of all the possible
cash flows, weighted according to their
probabilities.

All cash flows need to be AFTER TAX.

Three “Periods” During Project
1. Start of project
2. Each year throughout the project
3. End of life of project
1. Start of a Project Cash Flows
A. Initial investment to purchase the fixed
assets.
B. Initial working capital investment.
C. Cash received from the disposal of the
old machine, if sold.
2. During the Project Cash Flows
A. Increased sales
B. Decreased operating expenses
C. Another cash investment
D. Subsequent working capital investment.
E. Depreciation tax shield
Depreciation Tax Shield
The amount of tax deductible depreciation
will be a reduction of the company’s
taxable income, because depreciation
expense is a tax deductible expense.

Amount of tax depreciation * Marginal tax

rate
3. End of a Project Cash Flows
A. Cash received from the disposal of
equipment
B. Recovery of working capital.
Irrelevant Cash Flows
• Sunk costs
• Allocated common costs
• Financing cash flows
Capital Budgeting Methods
1. Payback period and
2. Discounted payback period
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Accounting rate of return (ARR)
Payback Method and
Discounted Payback
Method
Payback Method
The number of periods that must pass
before the net after-tax cash inflows from
the investment equals (or “pays back”) the
initial investment cost.
If incoming cash flows are constant over the
project life, the payback period is calculated:
Initial net investment
Periodic constant expected cash flow
Example: A company is considering the purchase of a
new piece of equipment to introduce a new product line.
• The equipment will cost 125,000 including setup
costs, installation, and testing.
• The estimated before-tax annual cash flow from
operations is 50,000.
• The company has a 30% effective income tax rate.
• The equipment has an economic life of five years
and is depreciated using the straight-line method.
• The company’s required rate of return is 10%.
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
(125,000)          
Investment
After-Tax CF
from Oper.  
35,000 35,000 35,000 35,000 35,000
(50,000 ×  
(1 – 0.30))
Depr. Tax Shield
 
([125,000 ÷ 5] 7,500 7,500 7,500 7,500 7,500
 
× 0.30)
Total After Tax
(125,000) 42,500 42,500 42,500 42,500 42,500
CF Payback period = 125,000 / 42,500 = 2.94 years
Payback period is calculated as follows:

125,000 / 42,500 = 2.94 years

Discounted Payback Method
Deals with the the payback method’s
weakness of not considering time value
of money concepts.

Uses the present value of cash flows to

calculate the payback period.
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
(125,000)          
Investment
After-Tax CF  
35,000 35,000 35,000 35,000 35,000
from Oper.  
Depr. Tax Shield   7,500 7,500 7,500 7,500 7,500
Total After Tax
(125,000) 42,500 42,500 42,500 42,500 42,500
CF
PV of $1 Factor 1.000 .909 .826 .751 .683 .621
Discounted Cash
(125,000) 38,633 35,105 31,918 29,028 26,393
Flow
Cumulative (86,367 (51,262 (19,344
(125,000) 9,684 36,077
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
(125,000)          
Investment
After-Tax CF  
35,000 35,000 35,000 35,000 35,000
from Oper.  
Depr. Tax Shield   7,500 7,500 7,500 7,500 7,500
Total After Tax
(125,000) 42,500 42,500 42,500 42,500 42,500
CF
PV of $1 Factor 1.000 .909 .826 .751 .683 .621
Discounted Cash
(125,000) 38,633 35,105 31,918 29,028 26,393
Flow
Cumulative (86,367 (51,262 (19,344
(125,000) 9,684 36,077
The cumulative cash flow from the project becomes positive
sometime during Year 4.

Number of the project year in the final year when cash flow is
negative: 3

Numerator = the positive value of the negative cumulative inflow

amount from the final negative year 19,344
Denominator = cash flow for the following year29,028
 
3 + (19,344 / 29,028) = 3.67 years
Net Present Value Method
Net Present Value Method
A project’s NPV is the PV of the project’s
future expected cash flows minus the
initial cash outflow.

The present value of the expected future

cash flows is calculated by using a
discount rate that is the company’s
required rate-of-return (RRR).
What Interest Rate to Use
Whatever required rate of return is used, it
must be appropriate to the project’s risk.
Example: A company is considering the purchase of a new piece
of equipment to introduce a new product line.
• The equipment will cost 125,000 including setup costs,
installation, and testing.
• The project will require a working capital investment of 15,000
at inception, which will be recovered at the end of the five-year
period.
• The estimated before-tax annual cash flows from
operations are 35,000, 40,000, 45,000, 50,000 and 55,000
over the next five years.
• The company has a 30% effective income tax rate.
• The equipment has an economic life of five years and is
depreciated using the straight-line method.
• The company’s required rate of return is 10%.
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
(125,000)          
Investment
Working Capital
(15,000) 15,000
Investment
After-Tax CF  
24,500 28,000 31,500 35,000 38,500
from Oper.  
Depr. Tax Shield 7,500 7,500 7,500 7,500 7,500
Total After Tax
(140,000) 32,000 35,500 39,000 42,500 61,000
CF
PV of $1 Factor 1.000 .909 .826 .751 .683 .621
Discounted Cash
Effect of Different Interest Rates
Higher rate means lower NPV of future
cash flows.
Internal Rate of Return
Internal Rate-of-Return Method
Calculates the interest rate at which the
NPV is $0.
Evaluating the Internal Rate of Return
If the IRR is higher than the required rate
of return, the project is acceptable.

If the IRR is lower than the required rate of

return, the project is not acceptable
and should not be considered further.
Accounting Rate of Return
Accounting Rate of Return Method
A ratio of the incremental net income to
the required investment.

Incremental Annual Avg. Accounting Net

Income
Net Initial Investment
Example: A company is considering the purchase of a
new piece of equipment to introduce a new product line.
• The equipment will cost 125,000 including setup
costs, installation, and testing.
• The estimated before-tax annual incomes from
operations (excluding depreciation) are 35,000,
40,000, 45,000, 50,000 and 55,000 over the next
five years.
• The company has a 30% effective income tax rate.
• The equipment has an economic life of five years
and is depreciated using the straight-line method.
  
Net Before-
Tax Net After-
Before-Tax Operating Tax
Operating Income Operating
Income Reduced by Income
(Excluding Depreciatio Depreciatio (Before-Tax
Depreciation) n n OI × (1−0.30)
Year 1 35,000 25,000 10,000 7,000
Year 2 40,000 25,000 15,000 10,500
Year 3 45,000 25,000 20,000 14,000
Year 4 50,000 25,000 25,000 17,500
Year 5 55,000 25,000 30,000 21,000
  
Net Before-
Tax Net After-
Before-Tax Operating Tax
Operating Income Operating
Income Reduced by Income
(Excluding Depreciatio Depreciatio (Before-Tax
Depreciation) n n OI × (1−0.30)
Year 1 35,000 25,000 10,000 7,000
Year 2 40,000 25,000 15,000 10,500
Year 3 45,000 25,000 20,000 14,000
Year 4 50,000 25,000 25,000 17,500
Year 5 55,000 25,000 30,000 21,000
Accounting rate of return calculated using the initial investment
in the denominator:
ARR = 14,000 ÷ 125,000 = 0.112 or 11.2%

Accounting rate of return calculated using the average

investment in the denominator:
ARR = 14,000 ÷ 62,500 = 0.224 or 22.4%
 
Basic Taxation
Two Basic Measures
1. Tax base
2. Tax rate structure
1. Tax Base
The tax base is the value on which the tax
is levied.
A tax base can be either a:
A. Stock measure, or
B. Flow measure.
2. Tax Rate Structure
Determines the proportion of the tax
base that is due in taxes.
Example: The property tax on property valued at
$100,000 is $2.75 per $100 of assessed value. The
property tax due each year is ($100,000 ÷ $100) ×
$2.75 = $2,750.
Direct vs. Indirect Taxes
Direct taxes are paid directly to the
governmental taxing authority by the
taxpayer.

Indirect taxes are taxes that are collected

by one entity in the supply chain and
paid to the government.
Progressive, Proportional and Regressive
Taxes
Progressive taxes increase the percentage
of tax as an individual’s income increases.
Proportional taxes remain a constant
percentage of income at all levels of
income.
Regressive taxes decrease as a percentage
of income as income increases. Examples
are any tax that is a fixed amount or based
on something other than income.
Income Taxes
Income taxes in many countries are
collected from individuals, corporations,
and other taxable entities by the federal
government, regional governments and
cities.
Income Tax Rates
The marginal tax rate is the tax rate that
is charged on the next X amount of
income.
The average tax rate is calculated as the
taxpayer’s total tax liability divided by
the total taxable income.
The effective tax rate is total tax liability
divided by total income.
Example: In a country with a progressive income tax, the first 5,000
in taxable income earned by a taxpayer is not taxed, because all
taxpayers have an automatic deduction of 5,000 per year. The next
5,000 in taxable income is taxed at the rate of 10%. The next
15,000 in taxable income is taxed at 15%. The next 10,000 in
taxable income is taxed at 20%, and income greater than $35,000 is
taxed at 25%.
A taxpayer with 30,000 in taxable income in a year’s time would
owe income tax of 3,750.
(5,000 × 0%) = 0
+ (5,000 × 10%) = 500
+ (15,000 × 15%) = 2,250
+ (5,000 × 20%) = 1,000
= 3,750
The taxpayer’s current marginal tax rate is 20%,
because taxable income above 30,000 up to 35,000
would be taxed at 20%.
A taxpayer who earned taxable income of 30,000 and
paid 3,750 in income tax would have an average tax rate
of 3,750 divided by 30,000, or 12.5%.
If municipal bonds are tax-exempt and the taxpayer in the
example had tax-exempt municipal bonds that earned
1,250 in interest during the year, the taxpayer’s total
income for the year would be 31,250, although taxable
income would be only 30,000. The taxpayer’s effective
tax rate would be 3,750 divided by 31,250, or 12%.
Income Taxes and Inflation
If inflation adjustments to income move people
into a higher tax bracket, they have to pay a
higher percentage of their income in taxes.
However, if the income tax rates are indexed
for inflation, then the tax brackets increase
each year so that people do not move into a
higher tax bracket as a result of a salary
increase that just keeps up with inflation.
Sales and Excise Taxes
A sales tax is levied on most sales of goods
and services by local taxing authorities.

Excise taxes are levied only on specific

items, such as gasoline or automobile
tires. The tax is added to the sales price
of the item and is remitted to the
government.
Property Taxes
Property taxes are based on the value of
taxable property, which includes
residential property and business
property (fixed assets and inventory).
A property tax is not based on income or
on buying or selling. It is based on
wealth or, more specifically, the value of
property that is owned.
Payroll Taxes
Payroll taxes are levied on wages and
salaries paid to employees.
Value Added Tax
Many industrial nations have adopted a
value added tax (VAT), which is a tax on
consumption.

Since consumers ultimately pay the VAT,

people in lower-income groups will spend
a greater proportion of their income on
the tax. Thus, VAT is a regressive tax.
Transfer Pricing
Transfer Pricing
The transfer price is the price charged by one unit
of the company to another unit of the same
company for the services or goods produced by
the first unit and “sold” to the second unit.
Goals of a Transfer Pricing System
• Promote goal congruence
• It must give senior management the information it needs to
evaluate the performance of the profit centers
• It must motivate the profit center managers to pursue their
own profit goals while also working towards the success of the
company as a whole
• It must encourage the cost center managers’ efficiency while
maintaining their autonomy as managers of profit centers
• It must be equitable, permitting each unit of a company to earn
a fair profit for the functions it performs
• It must meet legal and external reporting requirements
• It should be easy to apply
Setting the Transfer Price
Ultimately, the method used to calculate
the transfer price is determined by top
management.
1. Market Price
The transfer price is set as the current price
of the selling division’s product in an arm’s-
length transaction.
2. Cost of Production + Opportunity
Cost
Includes not only the cost of production,
but also the contribution that the selling
department gives up by selling internally
rather than externally.
3. Variable Cost
Only the variable costs of the selling
division.
4. Full Cost
The full cost of production including all
materials, labor, and a full allocation of
overhead.
5. Cost Plus
A fixed dollar amount or percentage of
costs is added to the cost of production
(the cost of production is defined in the
contract).
6. Negotiated Price
The selling and buying departments agree
on a price.
7. Arbitrary Pricing
Central management decides on a price to
achieve some overall objective such as tax
minimization.
8. Dual-Rate Pricing
The selling and purchasing departments
each record the transaction at different
prices.
What Method Should be Used
In deciding which method to use,
management considers:
• The goals of the company
• The capacity of the producing
department
• Legal and regulatory requirements and
limitations
Transfer Pricing and Capacity
If the producing department has excess capacity and
can produce what is required by the other department,
the minimum price that they will charge is the variable
cost of production.
If the producing department does not have excess
capacity, they will need to charge a transfer price that:
• Covers the variable costs of production, and
• Recovers any lost contribution from the units that
they are not able to produce because of this order.
Example: Blitz Corporation has two divisions – A and B. Division B currently
operates at 100% of its capacity and produces two products: widgets and
gadgets. Division B sells both products to outside customers for $15 and $30 per
unit, respectively. The variable costs for widgets are $10 per unit, and fixed costs
are $3 per unit at the current production level. For gadgets, the variable costs are
$16 per unit, and fixed costs are $8 at the current production level.
Division A, which currently purchases widgets from an outside supplier for $16 per
unit, would like to purchase 150 widgets from Division B annually.
However, if Division B increases the production of widgets to meet the demand of
Division A, it must stop producing gadgets entirely.
Also, to meet stricter quality requirements of Division A, Division B must increase
materials cost by $0.80 per widget, but the marketing and transportation cost per
widget will be reduced by $0.50 per unit. The total number of units of gadgets
produced and sold by Division B is 50 units per year.
What is the price range within which the transfer price for widgets would satisfy
both divisions?
The transfer price acceptable for the seller, the buyer, and the
whole company should be:
1) Higher than the variable costs (VC) plus the opportunity
cost (OC) of forgone production and sales for the seller
(lost contribution margin) per unit. This is the minimum price
that the selling department needs to receive, and
2) Lower than the market price of the product per unit. This
is the maximum amount that the buying department would be
willing to pay.
Expressed as a formula:
VC + OC ≤ Transfer Price ≤ Market Price
We need to solve for the variable cost, opportunity cost, and
market price.
Variable cost for widgets produced by Division B for Division A is
$10.30 per unit ($10 + $0.80 – $0.50).
The contribution margin lost on each gadget that Division B could
not produce is $30 – $16 = $14. The total contribution margin lost
for those 50 gadgets is $700 (50 units × $14 per unit).
The opportunity cost that is given up for the production of each
widget for Division A is $4.67 ($700 ÷ 150 units).
Adding the variable costs per unit and the opportunity cost per
unit together, we get the minimum transfer price of $14.97
($10.30 variable costs + $4.67 opportunity cost).

The market price (the maximum transfer price) for a widget

is $16.