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Chapter 2

Chapter 2. The Business, Tax, and Financial Environments. After studying Chapter 2, you should be able to:. Describe the three basic forms of business organisation – and the advantages and disadvantages of each. Understand various methods of depreciation.

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Chapter 2

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  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 organisation – 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. Summary • Business environment • Types of business • Strengths and weaknesses • 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

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

  5. 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.

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

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

  8. 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.

  9. 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

  10. 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.

  11. 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.

  12. 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

  13. 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.

  14. 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

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

  16. 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.

  17. 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 • Superannuation and pension funds • Merchant banks • Specialised government funding agencies etc

  18. Flow of Funds in the Economy • Financial Intermediaries • Savers lend tolend to • Interest Interest Banks Insurance Pension Funds Finance Coys Borrowers Savers

  19. 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.

  20. 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

  21. 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

  22. 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.

  23. 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.

  24. 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.

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