Chapter # 02

The Business, Tax, and Financial

Environments
 Learning Outcomes
After studying this lecture, you will be able to:
1. Describe the three basic forms of business
organization – and the advantages and disadvantages
of each.
2. Understand why acquiring assets using debt financing
offers a tax advantage over both common and
preferred stock financing.
3. Describe the purpose and make up of financial
markets.
4. Understand different factors affecting expected return
of securities.
 Summary
• Business environment
• Types of business
• Strengths and weaknesses
• Tax environment
• Ordinary income
• Interest and dividend income
• Capital gain
• Financial environment
• Financial institutions borrow and lend
• Financial markets – new issues to the public, and secondary
market
• Private placement
• Interest rates
• Yield curve
• What effects the interest rate
 The Business Environment
There are three basic forms of business
organization:
• Sole Proprietorships: A business owned by one
person and operated for his or her own profit
• Partnerships: A business operated by two or
more people together for a profit. (general and
limited)
• Corporations: An intangible business entity
created by law and is a separate ‘entity’ to its
owners.
 The Business Environment
• Strengths of the basic legal forms of business organisation
 The Business Environment
• Weaknesses of the basic legal forms of business organisation
 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.
 Summary for Sole Proprietorship
Advantages Disadvantages
• Simplicity • Unlimited liability
• Hard to raise additional
• Low setup cost capital
• Business entity limited
• Quick setup to life of owner
• Least regulated • Can have limited access
to outside funding for
• Owner keeps all the business
profits
 The Business Environment
Partnership – A business form in which
two or more individuals act as owners.

• 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 Disadvantages
• Can be simple • Unlimited liability for
• Low setup cost, the general partner
higher than sole • Difficult to raise
proprietorship additional capital, but
• Relatively quick easier than sole
setup proprietorship
• Limited liability for • Transfer of ownership
limited partners difficulties
 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.
 Summary for Corporation
Advantages Disadvantages
• Business is legal, • Double taxation of
separate entity from company profits
owners • More difficult to
• Limited liability establish
• Easy transfer of • More expensive to
ownership set up and maintain
• Unlimited life
• Easier to raise large
quantities of capital
 Business Taxes Environment

• Both individuals and businesses must pay taxes on

income.
• The income of sole proprietorships and partnerships is
taxed as the income of the individual owners, whereas
corporate income is subject to corporate taxes.
• Both individuals and businesses can earn two types of
income—ordinary income and capital gains income.
• Under current law, tax treatment of ordinary income
and capital gains income change frequently due
frequently changing tax laws.
Corporate Tax Rate Schedule
 Business Taxes: Ordinary Income

• Ordinary income is earned through the sale of a

firm’s goods or services and is taxed at the rates
depicted in Table on the previous slide.
Example
Weber Manufacturing Inc. has before-tax earnings of $250,000.
Tax = $22,500 + [0.39  ($250,000 – $100,000)]
Tax = $22,500 + (0.39  $150,000)
Tax = $22,500 + $58,500 = $80,750
 Business Taxation:
Marginal versus Average Tax Rates
• A firm’s marginal tax rate represents the rate at which
additional income is taxed.
• The average tax rate is the firm’s taxes divided by taxable
income.

Example
What are Webster Manufacturing’s marginal and average tax
rates?
Marginal Tax Rate = 39%
Average Tax Rate = $80,750/$250,000 = 32.3%
 Business Taxation:
Interest and Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion moderates the effect of double
taxation, which occurs when after-tax corporate
earnings are distributed as cash dividends to
stockholders, who then must pay personal taxes on
the dividend amount.
• Unlike dividend income, all interest income received
is fully taxed.
 Business Taxation:
Tax-Deductible Expenses
• In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.

Example
Two companies, Debt Co. and No Debt Co., both expect in
the coming year to have EBIT of $200,000. During the year,
Debt Co. will have to pay $30,000 in interest expenses. No
Debt Co. has no debt and will pay not interest expenses.
 Business Taxation:
Tax-Deductible Expenses (cont.)
 Business Taxation:
Tax-Deductible Expenses (cont.)

• As the example shows, the use of debt financing

can increase cash flow and EPS, and decrease
taxes paid.
• The tax deductibility of interest and other
certain expenses reduces their actual (after-tax)
cost to the profitable firm.
• It is the non-deductibility of dividends paid that
results in double taxation under the corporate
form of organization.
 Business Taxation: Capital Gains
• A capital gain is the amount by which the sale price of an
asset exceeds the asset’s purchase price.
• For corporations, capital gains are added to ordinary
income and taxed like ordinary income at the firm’s
marginal tax rate.

Example
Ross Company has just sold for $150,000 and asset that was
purchased 2 years ago for $125,000. Because the asset was
sold for more than its initial purchase price, there is a capital
gain of $25,000 ($150,000 - $125,000).
 Business Taxation: Carry Back & Carry Forward
• If a corporation sustains a net operating loss, this loss may generally be
carried back 2 years and forward up to 20 years to offset taxable income
in those years.
• Any loss carried back must first be applied to the earliest preceding year.
• If a firm sustained an operating loss of $400,000 in 2022, it would first carry this
loss back to 2020. If the company had net profits of $400,000 in that year and
paid taxes of $136,000, it would recompute its taxes for 2020 to show zero
profit for tax purposes. Consequently, the company would be eligible for a tax
refund of $136,000. If the 2022 operating loss was greater than operating
profits in 2020, the residual would be carried back to 2021 and taxes
recomputed for that year.
• However, if the net operating loss was greater than the net operating income in
both years, the residual would be carried forward in sequence to future profits
in 2023 to 2042.
• Profits in each of these years would be reduced for tax purposes by the amount
of the unused loss carried forward.
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 Financial Environment

• External funds can be sourced three ways:

• Financial institutions
• Financial markets
• Private placement
 Financial Environment
• 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.
 Financial Environment
• Financial Institutions:
• Organisations that take the savings of
individuals, businesses and governments and
turn them into loans or investments with other
organisations.
• Many different types:
• Banks, building societies, credit unions
• Life insurance and finance companies
• Pension funds
• Merchant banks
• Specialised government funding agencies etc
 Flow of Funds in the Economy

Financial Intermediaries

Savers Banks Borrowers

Insurance
lend to lendFunds
Pension to

Interest Interest
 Allocation of Funds
• 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.
 What Influences Security Expected Returns?

• 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.
 What Influences Expected Security Returns?

• 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.
What Influences Expected Security Returns?
• 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.
 Term Structure of Interest Rates

Upward Sloping Yield Curve

0 2 4 6 8 10

(Usual)
YIELD (%)

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.
 Risk-Expected Return Profile

Speculative Common Stocks

EXPECTED RETURN (%)

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