Chapter2TheBusiness,Tax,andFinancialEnvironmentsTheBusiness,Tax,andFinancialEnvironmentsTheBusinessEnvironmentTheTaxEnvironmentTheFinancialEnvironmentTheBusinessEnvironmentSoleProprietorshipsPartnerships(generalandlimited)CorporationsLimitedliabilitycompaniesTheU.S.hasfourbasicformsofbusinessorganization:TheBusinessEnvironmentOldestformofbusinessorganization.Businessincomeisaccountedforontheowner’spersonal

incometaxform.SoleProprietorship

--Abusinessformforwhichthereisoneowner.Thissingleownerhasunlimitedliabilityforalldebtsofthefirm.Summaryfor

SoleProprietorshipAdvantagesSimplicityLowsetupcostQuicksetupSingletaxfilingonindividualformDisadvantagesUnlimitedliabilityHardtoraiseadditionalcapitalTransferofownershipdifficultiesTheBusinessEnvironmentBusinessincomeisaccountedforoneachpartner’spersonal

incometaxform.Partnership--Abusinessforminwhichtwoormoreindividualsactasowners.TypesofPartnershipsLimitedPartnership

--Limitedpartnershaveliabilitylimitedtotheircapitalcontribution(investorsonly).Atleastonegeneralpartnerisrequiredandallgeneralpartnershaveunlimitedliability.GeneralPartnership

--Allpartnershaveunlimitedliabilityandareliableforallobligationsofthepartnership.SummaryforPartnershipAdvantagesCanbesimpleLowsetupcost,higherthansoleproprietorshipRelativelyquicksetupLimitedliabilityforlimitedpartnersDisadvantagesUnlimitedliabilityforthegeneralpartnerDifficulttoraiseadditionalcapital,buteasierthansoleproprietorshipTransferofownershipdifficultiesTheBusinessEnvironmentAnartificialentitythatcanownassetsandincurliabilities.Businessincomeisaccountedforontheincometaxformofthecorporation.Corporation--Abusinessformlegallyseparatefromitsowners.SummaryforCorporationAdvantagesLimitedliabilityEasytransferofownershipUnlimitedlifeEasiertoraiselargequantitiesofcapitalDisadvantagesDoubletaxationMoredifficulttoestablishMoreexpensivetosetupandmaintainTheBusinessEnvironmentBusinessincomeisaccountedforoneach“member’s”individualincometaxform.LimitedLiabilityCompanies

--Abusinessformthatprovidesitsowners(called“members”)withcorporate-stylelimitedpersonalliabilityandthefederal-taxtreatmentofapartnership.LimitedLiabilityCompany(LLC)LimitedliabilityCentralizedmanagementUnlimitedlifeTransferofownershipwithoutotherowners’priorconsentGenerally,anLLCwillpossessonlythefirsttwoofthefollowingfourstandardcorporationcharacteristicsSummaryforLLCAdvantagesLimitedliabilityEliminatesdoubletaxationNorestrictiononnumberortypeofownersEasiertoraiseadditionalcapitalDisadvantagesLimitedlife(generally)Transferofownershipdifficulties(generally)CorporateIncomeTaxesIncomeTaxExampleLisaMillerofBasketWonders(BW)iscalculatingthe

incometaxliability,marginaltaxrate,

and

averagetaxrateforthefiscalyearendingDecember31.BW’scorporatetaxableincomeforthisfiscalyearwas$250,000.IncomeTaxExampleMarginaltaxrate

=39%Averagetaxrate

=$80,750

/$250,000 =32.3%Incometaxliability

=$22,250+.39x($250,000-$100,000)=$22,250+$58,500 =$80,750DepreciationGenerally,profitablefirmsprefertouseanacceleratedmethodfortaxreportingpurposes.Depreciationrepresentsthesystematicallocationofthecostofacapitalassetoveraperiodoftimeforfinancialreportingpurposes,taxpurposes,orboth.CommonTypesofDepreciation

Straight-line(SL)

AcceleratedTypesDouble-Declining-Balance(DDB)ModifiedAcceleratedCostRecoverySystem(MACRS)DepreciationExampleLisaMillerofBasketWonders(BW)iscalculatingthedepreciationonamachinewithadepreciablebasisof$100,000,

a6-yearusefullife,anda5-yearpropertyclasslife.ShecalculatestheannualdepreciationchargesusingMACRS.MACRSExampleAssetsaredepreciatedbasedononeofeightdifferentpropertyclasses.Generally,thehalf-yearconventionisused.DepreciationinanyparticularyearisthemaximumofDDBorstraight-line.AswitchindepreciationmethodsismadefromDDBtoSLduringthelifeoftheasset.MACRSExampleMACRSScheduleOtherTaxIssuesQuarterlyTaxPayments

requirecorporationstopay25%oftheirestimatedannualtaxliabilityonthe15thofApril,June,September,andDecember.AlternativeMinimumTax

isaspecialtaxwhichequals20%ofalternativeminimumtaxableincome(generallynotequaltotaxableincome).CorporationspaythemaximumofAMTorregulartaxliability.InterestDeductibilityInterestExpense

istheinterestpaidonoutstandingdebtandistaxdeductible.CashDividend

isthecashdistributionofearningstoshareholdersandisnotataxdeductibleexpense.Theafter-taxcostofdebtis: (InterestExpense)X(1-TaxRate)Thus,debtfinancinghasataxadvantage!HandlingCorporateLossesandGainsLossesaregenerallycarriedbackfirstandthenforwardstartingwiththeearliestyearwithoperatinggains.Corporationsthatsustainanetoperatinglosscancarrythatlossback(Carryback)2yearsandforward(Carryforward)20yearstooffsetoperatinggainsinthoseyears.CorporateLossesandGainsExampleLisaMillerisexaminingtheimpactofanoperatinglossatBasketWonders(BW)in2003.Thefollowingtimelineshowsoperatingincomeandlosses.Whatimpactdoesthe2003losshaveonBW?-$500,000

$100,000

$150,000$150,0002003200220012000CorporateLossesandGainsExampleThelosscanoffsetthegainineachoftheyears2001and2002.Theremaining$250,000canbecarriedforwardto2004orbeyond.-$500,000

$100,000

$150,000$150,0002003200220012000-$150,000-$100,000$250,000$150,00000-$250,000CorporateCapitalGains/LossesOftenhistorically,capitalgainsincomehasreceivedmorefavorableU.S.taxtreatmentthanoperatingincome.Generally,thesaleofa“capitalasset”(asdefinedbytheIRS)generatesacapitalgain(assetsellsformorethanoriginalcost)orcapitalloss(assetsellsforlessthanoriginalcost).CorporateCapitalGains/LossesCapitallossesaredeductibleonlyagainstcapitalgains.Currently,capitalgainsaretaxedatordinaryincometaxratesforcorporations,oramaximum35%.PersonalIncomeTaxesTheU.S.hasaprogressivetaxstructurewithfourtaxbracketsof15%,28%,31%,

and36%.A10%surtaxisappliedtocertainhighincomeindividualsraisingtheirmarginalrateto39.6%.Personalincometaxesaredeterminedbytaxableincome,filingstatus,andvariouscredits.FinancialEnvironmentBusinessesinteractcontinuallywiththefinancialmarkets.FinancialMarkets

arecomposedofallinstitutionsandproceduresforbringingbuyersandsellersoffinancialinstrumentstogether.Thepurposeoffinancialmarketsistoefficientlyallocatesavingstoultimateusers.FlowofFunds intheEconomyINVESTMENTSECTORFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETFlowofFunds intheEconomyFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETINVESTMENTSECTORBusinessesGovernmentHouseholdsINVESTMENTSECTORFlowofFunds intheEconomyFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETSAVINGSSECTORHouseholdsBusinessesGovernmentINVESTMENTSECTORFlowofFunds intheEconomyFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETFINANCIALBROKERSInvestmentBankersMortgageBankersINVESTMENTSECTORFlowofFunds intheEconomyFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETFINANCIALINTERMEDIARIESCommercialBanksSavingsInstitutionsInsuranceCos.PensionFundsFinanceCompaniesMutualFundsINVESTMENTSECTORFlowofFunds intheEconomyFINANCIALINTERMEDIARIESSAVINGSSECTORFINANCIALBROKERSSECONDARYMARKETSECONDARYMARKETSecurityExchangesOTCMarketINVESTMENTSECTORAllocationofFundsInarationalworld,thehighestexpectedreturnswillbeofferedonlybythoseeconomicunitswiththemostpromisinginvestmentopportunities.Result:Savingstendtobeallocatedtothemostefficientuses.Fundswillflowtoeconomicunitsthatarewillingtoprovidethegreatestexpectedreturn(holdingriskconstant).Risk-ExpectedReturnProfileRISKEXPECTEDRETURN(%)U.S.TreasuryBills(risk-freesecurities)Prime-gradeCommercialPaperLong-termGovernmentBondsInvestment-gradeCorporateBondsMedium-gradeCorporateBondsPreferredStocksConservativeCommonStocksSpeculativeCommonStocksWhatInfluencesSecurityExpectedReturns?Marketabilityistheabilitytosellasignificantvolumeofsecuritiesinashortperiodoftimeinthesecondarymarketwithoutsignificantpriceconcession.DefaultRisk

isthefailuretomeetthetermsof