Chapter 2

The
The Business,
Business, Tax,
Tax,
and
and Financial
Financial
Environments
Environments
I

1
 The Business, Tax, and
Financial Environments

 The Business Environment

 The Tax Environment
 The Financial Environment

2
 The Business
Environment
There are four basic forms of
business organization:
 Sole Proprietorships
 Partnerships (general and limited)
 Corporations
 Limited liability companies
3
 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
the owner’s personal income tax form.
form
4
 Summary for
Sole Proprietorship
Advantages Disadvantages
 Simplicity  Unlimited liability
 Low setup cost  Hard to raise
additional capital
 Quick setup
 Transfer of
 Single tax filing
on individual form ownership
difficulties
5
 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

6
 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.
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 Summary for Partnership
Advantages Disadvantages
 Can be simple  Unlimited liability for
 Low setup cost, higher the general partner
than sole  Difficult to raise
proprietorship additional capital, but
 Relatively quick setup easier than sole
proprietorship
 Limited liability for
limited partners
 Transfer of ownership
difficulties
8
 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
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 Summary for Corporation
Advantages Disadvantages
 Limited liability  Double taxation
 Easy transfer of  More difficult to
ownership establish
 Unlimited life  More expensive
 Easier to raise large to set up and
maintain
quantities of capital
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 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
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 Limited Liability
Company (LLC)
Generally, an LLC will possess only the
first two of the following four standard
corporation characteristics
 Limited liability
 Centralized management
 Unlimited life
 Transfer of ownership without other
owners’ prior consent
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 Summary for LLC
Advantages Disadvantages
 Limited liability  Limited life
 Eliminates double (generally)
taxation  Transfer of
 No restriction on ownership
number or type of difficulties
(generally)
owners
 Easier to raise
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additional capital
 TAX RATE NON SALARIES
INDIVIDUAL AND ASSOCIATIONS
S. No TAXABLE INCOME RATE OF TAX
1. UP TO RS 400000 0%
2. RS 400001 TO 500000 7% ON AMOUNT
EXCEEDING 400000
3. RS 500000 TO 750000 RS 7000 + 10% AMOUNT
EXCEEDING 750000
4 RS 750000 to 1500000 32000 plus 15% AMOUNT
EXCEEDING 750000
5. RS. 1500001 TO 2500000 RS 144500 + 20% AMOUNT
EXCEEDING 1500000
6. RS. 2500001 TO 4000000 RS 344500 + 25% AMOUNT
EXCEEDING 2500000
7. RS. 4000001TO 6000000 RS 719500 + 30% AMOUNT
EXCEEDING 2500000
8. Amount exceeding 6000000 RS 131900 + 35% AMOUNT
EXCEEDING 6000000

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 TAX RATE FOR
SALARIED INDIVIDUALS
S. NO TAXABLE INCOME RATE OF TAX
1 UP TO RS 400000 0%

2. RS 400001 TO 500000 2% ON AMOUNT EXCEEDING 400000

3 RS 500001 TO 750000 RS 2000 + 5% AMOUNT EXCEEDING

500000

4 RS 750001 TO 1400000 RS 14500 + 10% AMOUNT EXCEEDING

750000

5 RS. 1400001 TO 1500000 RS79500+ 12.5% AMOUNT EXCEEDING

1500000

6 RS. 500001 TO1800000 RS7 92000+ 12.5% AMOUNT

EXCEEDING 1500000

7 RS. 2000001 TO 2500000 RS 175000 + 17.5

% AMOUNT EXCEEDING 2000000

8. RS 2500001 TO 3000000 RS 259000 + 20

% AMOUNT EXCEEDING 2500000

9. RS 3000001 TO 3500000 RS 259000 + 22.5

% AMOUNT EXCEEDING 3500000

10 RS3500001 TO 4000000 RS 359000 + 25%

AMOUNT EXCEEDING 3500000

11 RS 4000001 TO 7000000 RS 472000 + 27.5%

AMOUNT EXCEEDING 4000000

12 AMOUNT EXCEEDING Rs7000000 RS 1422000 + 30%% AMOUNT

15 EXCEEDING 7000000
 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
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 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
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users.
 Flow of Funds
in the Economy

INVESTMENT SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS

SECONDARY MARKET

SAVINGS SECTOR

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 Flow of Funds
in the Economy

INVESTMENT
SECTOR INVESTMENT
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Businesses

SECONDARY MARKET Government

Households
SAVINGS SECTOR

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 Flow of Funds
in the Economy

INVESTMENT
SECTOR SAVINGS
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Households

SECONDARY MARKET Businesses

Government
SAVINGS SECTOR

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 Flow of Funds
in the Economy

INVESTMENT
SECTOR FINANCIAL
BROKERS

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

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 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

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 Flow of Funds
in the Economy

INVESTMENT
SECTOR SECONDARY
MARKET

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

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 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
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most efficient uses.
 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
U.S. Treasury Bills (risk-free securities)

RISK
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 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.
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 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 Default

Investment grade represents the top four categories.

Below investment grade represents all other categories.
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 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.

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 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.
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 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.
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