The Business, Tax, and Financial Environments

The
The The

Business Environment
Tax Environment Financial Environment

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The Business Environment

:

Sole Proprietorships Partnerships (general and limited) Corporations

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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.

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Summary for Sole Proprietorship

Advantages
Simplicity Low

Disadvantages
Unlimited liability Hard to raise additional capital Transfer of ownership difficulties

setup cost setup

Quick Single

tax filing on individual form

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The Business Environment

Partnership -- A business form in which two or more individuals act as owners.
Business

income is accounted for on each partners personal income tax form.

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Types of Partners
General

Partner

Unlimited Liability Assumes Management Role

Every partnership must have at least one general partner

Limited

Partner
limited to Investment

Liability May

not take active managerial role

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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
Can Low

Disadvantages
Unlimited

be simple

setup cost, higher than sole proprietorship quick setup

liability for the general partner

Difficult

Relatively

to raise additional capital, but easier than sole proprietorship

of ownership difficulties

Limited

liability for limited partners

Transfer

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The Business Environment

Corporation -- A business form legally separate from its owners.
An

artificial entity that can own assets and incur liabilities.

income is accounted for on the income tax form of the corporation.

Business

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In

Pakistan corporations are registered under the companies ordinance 1984.

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TYPES
OF CORPORATION

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Public limited company

Shares are offered to general public Managed and controlled by the B.O.D Shares are traded in the stock exchange

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Private limited company

Stock owned by relatively few people shares are not offered to General public Shares are not transferable without the consent of members.

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Corporate Charter
Legal

Permission to Operate as a Corporation

by state not conduct business as a corporation without a charter

Issued May

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Contents of a Corporate Charter

Company Name & Address Names & addresses of Incorporators Purpose of the Corporation

Maximum

amount of stock & Classes of Stock to be issued

Rights & Privileges of stockholders Length of time the corporation is to exist

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Stockholder Rights

Common Stock
Votes One

in corporate matters

vote per share owned

Preferred Stock
No

voting rights claims are paid 1st

Dividend

Dividend
Distribution
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of earnings to the stockholders of a corporation

Summary for Corporation

Advantages
Limited Easy

Disadvantages
Double More

liability

taxation

transfer of ownership life

difficult to establish expensive to set up and maintain

Unlimited

More

Easier
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to raise large quantities of capital

The Modern Corporation

Modern Corporation
Shareholders Management

There exists a SEPARATION between owners and managers.

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Role of Management
Management acts as an agent for the owners (shareholders) of the firm.

An agent is an individual authorized by another person, called the principal, to act in the latters behalf.

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Agency Theory
Jensen

and Meckling developed a theory of the firm based on agency theory.

Theory is a branch of economics relating to the behavior of principals and their agents.

Agency

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Agency Theory
Principals

must provide incentives so that management acts in the principals best interests and then monitor results.
include, stock options, perquisites, and bonuses.

Incentives

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Corporate Governance
Corporate

governance: represents the system by which corporations are managed and controlled.
Includes

shareholders, board of directors, and senior management.

Then

shareholder wealth maximization remains the appropriate goal in governing the firm.

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Organization of the Financial Management Function

Board of Directors
President (Chief Executive Officer)
Vice President Operations

VP of Finance

Vice President Marketing

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Organization of the Financial Management Function

VP of Finance
Treasurer
Capital Budgeting Cash Management Credit Management Dividend Disbursement Fin Analysis/Planning Pension Management Insurance/Risk Mngmt Tax Analysis/Planning
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Controller
Cost Accounting Cost Management Data Processing General Ledger Government Reporting Internal Control Preparing Fin Stmts Preparing Budgets Preparing Forecasts

TAX ENVIRONMENT

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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.

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Common Types of Depreciation

Straight-line (SL)
Accelerated Types

Double Declining Balance (DDB)

Modified Accelerated Cost Recovery System (MACRS)

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MACRS Example

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Assets are depreciated based on one of eight different property classes. Generally, the half-year convention is used. Depreciation in any particular year is the maximum of DDB or straight-line. A switch in depreciation methods is made from DDB to SL during the life of the asset.

MACRS Schedule
Recovery Year 1 2 3 4 5 6 7 8
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Property Class 3-Year 5-Year 33.33% 20.00% 44.45 32.00 14.81 19.20 7.41 11.52 11.52 5.76

7-Year 14.29% 24.49 17.49 12.49 8.93 8.92 8.93 4.46

Interest Deductibility
Interest Expense is the interest paid on outstanding debt and is tax deductible. Cash Dividend is the cash distribution of earnings to shareholders and is not a tax deductible expense. Thus, debt financing has a tax advantage!
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Financial Environment
Businesses

interact continually with the financial markets. Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.

Financial

The
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purpose of financial markets is to efficiently allocate savings to ultimate users.

Why study Financial Markets and Institutions?

They

are the cornerstones of the overall financial system in which financial managers operate use both for investing and governments use both for financing

Individuals

Corporations

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Overview of Financial Markets

Primary

Markets versus Secondary Markets Markets versus Capital Markets

Money

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Primary Markets versus Secondary Markets

Primary

Markets

markets

in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) Markets where financial instruments are traded among investors (e.g. NYSE,KSE)

Secondary markets

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Money Markets versus Capital Markets

Money Markets
markets

that trade debt securities with maturities of one year or less (e.g. Commercial papers, Treasury bills) that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

Capital Markets
markets

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Flow of Funds in a World without FIs: Direct Transfer

Financial Claims (Equity and debt instruments) Users of Funds (Corporations) Cash Example: A firm sells shares directly to investors without going through a financial institution Suppliers of Funds (Households)

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Flow of Funds in a world with FIs: Indirect transfer

Users of Funds FI (Brokers) Suppliers of Funds

Financial Claims (Equity and debt securities)

FI (Asset transformers)

Financial Claims (Deposits and Insurance policies)

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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:
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Savings tend to be allocated to the most efficient uses.