1 Chapter 2 Chapter 2 The Business, The Business, Tax, and Tax, and Financial Financial Environments Environments
May 13, 2015
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Chapter 2Chapter 2
The Business, Tax, The Business, Tax, and Financial and Financial EnvironmentsEnvironments
The Business, Tax, The Business, Tax, and Financial and Financial EnvironmentsEnvironments
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The Business, Tax, and The Business, Tax, and Financial EnvironmentsFinancial Environments
The Business Environment
The Tax Environment
The Financial Environment
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The Business The Business EnvironmentEnvironment
Sole Proprietorships
Partnerships (general and limited)
Corporations
Limited liability companies
The PAK has four basic forms of The PAK has four basic forms of business organization:business organization:
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The Business The Business EnvironmentEnvironment
Oldest form of business organization.
Business income Business income is accounted for on the owner’s personalpersonal income tax formincome tax form.
Sole ProprietorshipSole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.
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Summary for Summary for Sole ProprietorshipSole Proprietorship
AdvantagesAdvantages Simplicity Low setup cost Quick setup Single tax filing on
individual form
DisadvantagesDisadvantages Unlimited liability Hard to raise
additional capital Transfer of
ownership difficulties as compared to corporations.
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The Business The Business EnvironmentEnvironment
Business income Business income is accounted for on each partner’s personalpersonal income tax formincome tax form.
PartnershipPartnership -- A business form in which two or more individuals act as owners.
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Types of PartnershipsTypes of Partnerships
Limited PartnershipLimited 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.
General PartnershipGeneral Partnership -- All partners have unlimited liability and are liable for all obligations of the partnership.
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Summary for PartnershipSummary for Partnership
AdvantagesAdvantages Can be simple Low setup cost, higher
than sole proprietorship
Relatively quick setup Limited liability for
limited partners
DisadvantagesDisadvantages Unlimited liability for
the general partner Difficult to raise
additional capital, but easier than sole proprietorship
Transfer of ownership is difficult because of legal requirements.
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The Business The Business EnvironmentEnvironment
An artificial entity that can own assets and incur liabilities on its name.Business income Business income is accounted for on the income tax income tax form of the corporationform of the corporation.
CorporationCorporation -- A business form legally separate from its owners.
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Summary for CorporationSummary for Corporation
AdvantagesAdvantages
Limited liability
Unlimited life
Easier to raise large quantities of capital
DisadvantagesDisadvantages
Double taxation
More difficult to establish
More expensive to set up and maintain
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The Business The Business EnvironmentEnvironment
Business income Business income is accounted for on each “member’s” individual income tax individual income tax formform.
Limited Liability CompaniesLimited 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.
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Limited Liability Limited Liability Company (LLC)Company (LLC)
Limited liability
Centralized management
Unlimited life
Transfer of ownership without other owners’ prior consent
Generally, an LLC will possess only the Generally, an LLC will possess only the first two of the following four standard first two of the following four standard
corporation characteristicscorporation characteristics
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Summary for LLCSummary for LLC
AdvantagesAdvantages
Limited liability
Eliminates double taxation
No restriction on number or type of owners
Easier to raise additional capital
DisadvantagesDisadvantages
Transfer of ownership difficulties (generally)
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TYPES TYPES
Public limited companyShares are given to general public.
S ALLIED BANK OF PAKISTAN
ASKARI COMMERCIAL BANK
Minimum number of shareholders is 7.
Private limited companyOwnership is restricted
Minimum number of shareholders is 2 and maximum is 20
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DepreciationDepreciation
Generally, profitable firms prefer to use an accelerated method for tax reporting purposes.
DepreciationDepreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax
purposes, or both.
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Common Types of Common Types of DepreciationDepreciation
Straight-line (Straight-line (SLSL))
Accelerated TypesAccelerated Types
Double-Declining-Balance (DDB)
Modified Accelerated Cost Recovery System (MACRS)
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Interest DeductibilityInterest Deductibility
Interest ExpenseInterest Expense is the interest paid on outstanding debt is an expense and is tax deductibletax deductible.
Cash Dividend is the cash distribution of earnings to shareholders and is not a tax deductible expense.
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What are career What are career opportunities in managerial opportunities in managerial finance for youfinance for you
Financial analyst
Cash manager
Credit analyst
Pension fund manager
Foreign exchange manager
Project finance manager
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Financial EnvironmentFinancial Environment
Businesses interact continually with the financial markets.financial markets.
Financial MarketsFinancial 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.
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Flow of Funds Flow of Funds in the Economyin the Economy
INVESTMENT SECTOR
FIN
AN
CIA
LIN
TE
RM
ED
IAR
IES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
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Flow of Funds Flow of Funds in the Economyin the Economy
FIN
AN
CIA
LIN
TE
RM
ED
IAR
IES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
INVESTMENTINVESTMENTSECTORSECTOR
Businesses
Government
Households
INVESTMENT INVESTMENT SECTORSECTOR
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Flow of Funds Flow of Funds in the Economyin the Economy
FIN
AN
CIA
LIN
TE
RM
ED
IAR
IES
SAVINGS SECTORSAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SAVINGSSAVINGSSECTORSECTOR
Households
Businesses
Government
INVESTMENT SECTOR
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Flow of Funds Flow of Funds in the Economyin the Economy
FIN
AN
CIA
LIN
TE
RM
ED
IAR
IES
SAVINGS SECTOR
FINANCIAL BROKERSFINANCIAL BROKERS
SECONDARY MARKET
FINANCIALFINANCIALBROKERSBROKERS
Investment Bankers
Mortgage Bankers
INVESTMENT SECTOR
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Flow of Funds Flow of Funds in the Economyin the Economy
FIN
AN
CIA
LF
INA
NC
IAL
INT
ER
ME
DIA
RIE
SIN
TE
RM
ED
IAR
IES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIES
Commercial BanksSavings Institutions
Insurance Cos.Pension Funds
Finance CompaniesMutual Funds
INVESTMENT SECTOR
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Flow of Funds Flow of Funds in the Economyin the Economy
FIN
AN
CIA
LIN
TE
RM
ED
IAR
IES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKETSECONDARY MARKET
SECONDARYSECONDARYMARKETMARKET
SecurityExchanges
OTCMarket
INVESTMENT SECTOR
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Allocation of FundsAllocation of Funds
In a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities.
ResultResult: : Savings tend to be allocated to the most efficient uses.
Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant).
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Financial marketsFinancial markets
Not physical places as they are mechanism for channeling savings to the ultimate investors in real assets.
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Money and capital marketMoney and capital market
Money market: it is the market for short term government and debt securities.
Capital market: the maturity for relatively long term financial instruments(e.g;bonds and stocks)
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Financial institutions Financial institutions
An intermediary that channels the savings of individuals,business,and government. Many financial institutions directly or indirectly pay savers interest on deposited funds, other provide services for a fee( for example, checking accounts)
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Financial intermediaryFinancial intermediary
These are financial institutions that accept money from savers and use those funds to make loans and other financial investments in their own name.
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Financial marketsFinancial markets
Forums in which suppliers of funds and demanders of funds can transact business directly
Primary market: private placement; is the sale of a new security issue,
typically bonds or preferred stock, directly to an investor or group of investor
Secondary market: place where renowned securities are traded
public offering; the nonexclusive sale of either bonds or stocks to the general public
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Financial Broker Financial Broker
Certain financial institutions perform a necessary brokerage function. when brokers bring together parties who need funds with those who have savings, they are not performing a direct lending function but rather are acting as middlemen
Investment bankers: financial institutions that underwrites new securities for resale.
Mortgage bankers: financial institution that buys mortgages primarily for resale. (involve in acquiring and placing mortgages)
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Types of brokersTypes of brokers
Brokerage firms Customers can choose the type of broker they wish to use. They
can be classified according to the services offered and fees charged.
FULL SERVICE BROKERS: A brokerage firm offering a full range of services including information and advice. Today investors need more information about economy,industries,individual companies and the bond market from full time brokers.
DISCOUNT BROKERS: Brokerage firms offering execution services at prices typically significantly less than full-line brokerage firms.Commisions vary widely by amount and the manner in which they are determined. Some discount brokers offer research information and investment recommendations.
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Risk-Expected Risk-Expected Return ProfileReturn Profile
RISK
EX
PE
CT
ED
RE
TU
RN
(%
)
U.S/Pakistan Treasury Bills (risk-free securities)U.S/Pakistan Treasury Bills (risk-free securities)Prime-grade Commercial PaperPrime-grade Commercial Paper
Long-term Government Bonds
Investment-grade Corporate Bonds
Medium-grade Corporate Bonds
Preferred Stocks
Common Stocks
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What Influences Security What Influences Security Expected Returns?Expected Returns?
MarketabilityMarketability is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession.
Default RiskDefault Risk is the failure to meet the terms of a contract.
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Ratings by Investment Ratings by Investment Agencies on Default RiskAgencies on Default Risk
MOODY’S INV SERVICE STANDARD & POOR’SAaa Best Quality AAA Highest GradeAa High Quality AA High GradeA Upper Med Grade A Higher Med Grade
Baa Medium Grade BBB Medium GradeBa Possess Speculative
ElementsBB Speculative
C Lowest Grade D In Default
Investment grade Investment grade represents the top four categories.Below investment grade represents all other categories.
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What Influences Expected What Influences Expected Security Returns?Security Returns?
TaxabilityTaxability considers the expected tax consequences of the security.
MaturityMaturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due.
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Term Structure of Term Structure of Interest RatesInterest Rates
A yield curve is a graph of the relationship between yields and term to maturity for particular securities.
Upward Sloping Yield CurveUpward Sloping Yield Curve
Downward Sloping Yield Curve
0
2
4
6
8
10
YIE
LD
(%
)
0 5 10 15 20 25 30
(Usual)
(Unusual)
YEARS TO MATURITY
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What Influences Expected What Influences Expected Security Returns?Security Returns?
InflationInflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return.
Embedded OptionsEmbedded Options provide the opportunity to change specific attributes of the security.
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Assignment /oral quizAssignment /oral quiz
In general, what would be the likely effect of the following occurrences on the money and capital markets?
The saving rate of individuals in the country declines.
Individuals increases their savings at saving and loan associations and decreases their savings at banks.