Chapter 2

The
The Business,
Business, Tax,
Tax,
and
and Financial
Financial
Environments
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. Describe the four basic forms of business organization in the
United States – and the advantages and disadvantages of each.
2. Understand how to calculate a corporation's taxable income and
how to determine the corporate tax rate - both average and
marginal.
3. Understand various methods of depreciation.
4. Understand why acquiring assets through the use of debt
financing offers a tax advantage over both common and
preferred stock financing.
5. Describe the purpose and make up of financial markets.
6. Demonstrate an understanding of how letter ratings of the major
rating agencies help you to judge a security’s default risk.
7. Understand what is meant by the term “term structure of interest
rates” and relate it to a “yield curve.”
2.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business, Tax, and
Financial Environments
• The Business Environment
• The Tax Environment
• The Financial Environment

2.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business
Environment
The US has four basic forms of
business organization:
• Sole Proprietorships
• Partnerships (general and limited)
• Corporations
• Limited liability companies
2.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
form

2.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
• Business income is accounted for on
each “member’s” individual income tax
form.
form
2.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Corporate Income Taxes
Corp. Taxable Income Tax
At Least But < Rate Tax Calculation
$ 0 $ 50,000 15% 0.15x(Inc > 0)
50,000 75,000 25% $ 7,500 + 0.25x(Inc > 50,000)
75,000 100,000 34% 13,750 + 0.34x(Inc > 75,000)
100,000 335,000 39% 22,250 + 0.39x(Inc > 100,000)
335,000 10,000,000 34% 113,900 + 0.34x(Inc > 335,000)
10,000,000 15,000,000 35% 3,400,000 + 0.35x(Inc > 10,000,000)
15,000,000 18,333,333 38% 5,150,000 + 0.38x(Inc > 15,000,000)
18,333,333 35% 6,416,667 + 0.35x(Inc > 18,333,333)

2.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
• Generally, profitable firms prefer to use
an accelerated method for tax
reporting purposes.
2.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common Types of
Depreciation
• Straight-line (SL)
• Accelerated Types
• Double Declining Balance
(DDB)
• Modified Accelerated Cost
Recovery System (MACRS)
2.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Depreciation Example
Lisa Miller of Basket Wonders (BW) is
calculating the depreciation on a machine
with a depreciable basis of $100,000, a 6-
year useful life,
life and a 5-year property
class life.
She calculates the annual depreciation
charges using MACRS. [Note – ignore
“bonus” depreciation discussed in 2–25]
2.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 MACRS Schedule
Recovery Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
2.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Markets
 Financial Markets are the
meeting place for people,
corporations, and institutions to
buy or sell securities.

2.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Kinds of Financial
Markets
 Public and corporate financial
markets.
 Domestic and international
markets.
 Money and capital markets.

2.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Money Markets
 Deals with short-term securities
that have a life of one year or less.
 Securities in these markets
include:
1. Commercial paper. It is a debt
instrument sold by Corporations
or Banks.
2.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Money Markets
2. Certificates of Deposit. It is a debt
instrument with a maturities of less
than 12 months sold by banks.
3. Banker’s Acceptance. It is a time
draft drawn on and accepted by
bank for import-export
transactions.
2.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Money Markets

4. Treasury Bills. It is short-term

securities with maturities of one
year or less issued at discount
from face value.

2.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Markets
 Deals with securities that have a life of
more than one year. Long-term
markets.
 Securities include:
1.Common Stock 2. Preferred Stock
3. Corporate & Government Bonds

2.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Kinds of Financial Markets
 1. Primary Market. Where new issued
securities are sold.
 2. Secondary Market (Stock -
Exchange Market). It is organized
marketplace where securities are
bought and sold amongst the
investors. Prices of securities keep
changing continually in this market.
2.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Kind of Investors
 1. Long-term Investors
 2. Speculators
 3. Gamblers

2.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Securities Analysis
 1. Fundamental Analysis
 2. Strategic Analysis
 3. Technical Analysis

2.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Securities Value
 1. Par Value (Subscription Value)
 2. Book value (Accounting Value)
 3. Market Value (Price of stock)
 4. Real Value (Good Well)

2.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS

SECONDARY MARKET

SAVINGS SECTOR

2.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT
SECTOR INVESTMENT
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Businesses

SECONDARY MARKET Government

Households
SAVINGS SECTOR

2.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT
SECTOR SAVINGS
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Households

SECONDARY MARKET Businesses

Government
SAVINGS SECTOR

2.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT
SECTOR FINANCIAL
BROKERS

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Investment
Bankers
SECONDARY MARKET
Mortgage
Bankers
SAVINGS SECTOR

2.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT
SECTOR FINANCIAL
INTERMEDIARIES

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Commercial Banks
Savings Institutions
SECONDARY MARKET Insurance Cos.
Pension Funds
Finance Companies
SAVINGS SECTOR
Mutual Funds

2.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT
SECTOR SECONDARY
MARKET

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Security
Exchanges
SECONDARY MARKET
OTC
Market
SAVINGS SECTOR

2.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
2.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Ratings by Investment
Agencies on Default Risk
MOODY’S INV SERVICE STANDARD & POOR’S
Aaa Best Quality AAA Highest Grade
Aa High Quality AA High Grade
A Upper Med Grade A Higher Med Grade
Baa Medium Grade BBB Medium Grade
Ba Possess Speculative BB Speculative
Elements

C Lowest Grade D In Payment Default

Investment grade represents the top four categories.

Below investment grade represents all other categories.
2.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.