Chapter 2

1. Chapter 2 The Business, Tax, and Financial Environments

2. After studying Chapter 2, you should be able to: • Describe the three basic forms of business organization – and the advantages and disadvantages of each. • 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.”

3. The Business, Tax, and Financial Environments • The Business Environment • The Tax Environment • The Financial Environment

4. The Business Environment There are three basic forms of business organisation: • 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. • There are other forms of business organisation, but we are not looking at them here.

5. The Business Environment • Strengths of the basic legal forms of business organisation

6. The Business Environment • Weaknesses of the basic legal forms of business organisation

7. 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 personalincome tax form.

8. Advantages Simplicity Low setup cost Quick setup Least regulated Owner keeps all profits Disadvantages Unlimited liability Hard to raise additional capital Business entity limited to life of owner Can have limited access to outside funding for the business Summary for Sole Proprietorship

9. 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 personalincome tax form.

10. 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.

11. Advantages Can be simple Low setup cost, higher than sole proprietorship Relatively quick setup Limited liability for limited partners Disadvantages Unlimited liability for the general partner Difficult to raise additional capital, but easier than sole proprietorship Transfer of ownership difficulties Summary for Partnership

12. The Business Environment • An 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.

13. Advantages Business is legal, separate entity from owners Limited liability Easy transfer of ownership Unlimited life Easier to raise large quantities of capital Disadvantages Double taxation of company profits More difficult to establish More expensive to set up and maintain Summary for Corporation

14. Depreciation Depreciationrepresents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. • Generally, profitable firms prefer to use an accelerated method for tax reporting purposes.

15. Common Types of Depreciation • Straight-line (SL) • Accelerated Types • Declining Balance (DB) • Modified Accelerated Cost Recovery System (MACRS)

16. Depreciation Example Lisa Miller of Basket Wonders (BW) is calculating the straight line depreciation on a machine with a depreciable basis of $100,000. It hasa 6-year useful life. She calculates the annual depreciation charge as follows: Depreciable value / useful life $100,000 / 6 = $16,667

17. Interest Deductibility Interest Expenseis the interest paid on outstanding debt and istax deductible. Cash Dividendis 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!

18. Handling Corporate Losses and Gains • In New Zealand, corporations that sustain a net operating loss can carry that loss forward (Carryforward)to offset operating gains in future years.

19. Corporate Losses and Gains Example Lisa Miller is examining the impact of an operating loss at Basket Wonders (BW) in 2007. The following time line shows operating income and losses. What impact does the 2005 loss have on BW? 2004 2005 2006 2007 $150,000 –$500,000 $100,000 $150,000

20. Corporate Losses and Gains Example The loss can offset the gains made in each of the years 2005 and 2006. The remaining $250,000 can be carried forward to 2008 or beyond. 2004 2005 2006 2007 $150,000 -$500,000 $100,000 $150,000 –$150,000 –$100,000 0 $150,000 –$250,000 0

21. 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).

22. Financial Environment • External funds can be sourced three ways: • Financial institutions • Financial markets • Private placement

23. Financial Environment • Businesses interact continually with the financial markets. • Financial Marketsare 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.

24. Financial Environment • Financial Institutions: • Intermediaries that channel the savings of individuals, businesses and governments into loans or investments. • Many different types: • Banks, building societies, credit unions • Life insurance and finance companies • Superannuation and pension funds • Merchant banks • Specialised government funding agencies etc

25. Flow of Funds in the Economy

26. 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.

27. Risk-Expected Return Profile Speculative Common Stocks Conservative Common Stocks Preferred Stocks Medium-grade Corporate Bonds Investment-grade Corporate Bonds EXPECTED RETURN (%) Long-term Government Bonds Prime-grade Commercial Paper US Treasury Bills (risk-free securities) RISK

28. What Influences Security Expected Returns? • Default Riskis 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.

29. Ratings by Investment Agencies on Default Risk Investment grade represents the top four categories. Below investment grade represents all other categories.

30. What Influences Expected Security Returns? • Maturityis 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.

31. Term Structure of Interest Rates A yield curve is a graph of the relationship between yields and term to maturity for particular securities. Upward Sloping Yield Curve (Usual) YIELD (%) 0 2 4 6 8 10 Downward Sloping Yield Curve (Unusual) 0 5 10 15 20 25 30 YEARS TO MATURITY

32. US Treasury Yield Curve (4 / 16 / 2008) This yield curve is the relationship of US Treasuries effective April 16, 2008 (see VW13E–02.xlsx).

33. What Influences Expected Security Returns? • Embedded Optionsprovide the opportunity to change specific attributes of the security. • Inflationis a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return.