Study Guide in Financial Management FM-AA-CIA-15 Rev.

0 03-June-2020

FM 101: Financial Management Module 2: The Business, Tax, and Financial Environment

Module No. 2
The Business, Tax, and Financial Environment

MODULE OVERVIEW
The role of financial managers play an important role in the business organizations, to understand their role,
the students must familiarize with the environment in which they operate.

LEARNING OBJECTIVES

1. Describe the three basic forms of business organization – and the advantages and disadvantages of
each.
2. l Understand how to find a corporation’s taxable income and how to determine the corporate tax rate
– both average and marginal.
3. l Understand various methods of depreciation.
4. l Explain why acquiring assets through the use of debt financing offers a tax advantage over both
common and preferred stock financing.
5. l Describe the purpose and makeup of financial markets.
6. l Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a
security’s default risk.
7. l Understand what is meant by the “term structure of interest rates” and relate it to a “yield curve.”
LEARNING CONTENTS

The Business Environment

What is a business environment?
A corporate environment is made up of internal and external elements, as well as a mix of the two.
Example: employees, management, customers, supply and demand, suppliers etc.

Forms of Business Organization

Sole Propreitorship
-The earliest type of company structure. As the name implies, one person owns the company, owns all
of its assets, and is personally liable for all of its obligations.
-A sole proprietorship does not have its own set of taxes. The owner simply adds any revenues or subtracts any
losses from the business when computing personal taxable income.
- The primary issue is that the owner is personally responsible for all business duties.

Partenerships
A partnership is identical to a sole proprietorship, with the exception that there are many owners. A partnership, like a sole
proprietorship, is tax-free. Individual partners, on the other hand, incorporate their portion of the firm' earnings or losses in
their personal taxable income. One possible benefit of this business structure is that it may typically attract more financing
than a sole proprietorship. Given a bigger owner investment base, lenders may be more willing to provide financing if
more than one owner is supplying personal resources.
-General Partnership - All partners have unlimited responsibility; they are jointly and severally accountable for
the partnership's liabilities. General partners should be carefully chosen since each partner has the ability to bind the
partnership with obligations.
-Limited Partnership - Limited partners in a limited partnership contribute money and are only liable for that
amount; they cannot lose more than they invest. However, the partnership must have at least one general partner with
unlimited responsibility. Limited partners are not involved in the day-to-day operations of the company; this is handled by
the general partner (s). The limited partners are purely investors who participate in the partnership's earnings and losses as
per the partnership agreement's requirements.

Corporations
A corporation is a legally established "artificial entity." It has the ability to own assets as well as incur obligations.
The main distinguishing aspect of this type of company structure is that the corporation exists legally apart from its
owners. An owner's responsibility is restricted to the amount of money he or she has invested. In comparison to sole
proprietorship and general partnership, limited liability is a significant benefit. The corporation's name can be used to
generate funds without exposing the proprietors to infinite responsibility. As a result, personal assets cannot be confiscated
in the course of resolving disputes.
Shares of stock serve as proof of ownership, to every shareholder holding the proportion of the company specified by his
or her shares in relation to the total number of shares in circulation. Another significant benefit of the company structure is
the ease with which these shares may be transferred. Because the company operates independently of its owners, it is not
constrained by their lives (unlike proprietorships and partnerships). Even if individual shareholders die or sell their stock,
the corporation can continue to survive. Because of the advantages of limited liability and quick ownership transfer

THE TAX ENVIRONMENT

A corporation’s taxable income is found by deducting all allowable expenses, including depreciation and interest, from
revenues.

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FM 101: Financial Management Module 2: The Business, Tax, and Financial Environment

For discussion purposes, all corporations are classified as domestic for simplicity.
*The income tax rate for corporations in Philippine settings is 25% for Domestic.
**Domestic Corporations are those established within the formalities of the Philippine Law.
***To compute for the taxable income of the Corporation:
Revenue (Sales or Service) XX
+ Other Related operation Income XX
=Total Revenue XX
-Related operation Expense XX
=Gross profit XX
-Interest Expense XX
-Depreciation Expense XX
=Net TaxableIncome XX
***Sole Propreitorships and Partnerships are taxed based on Income Individually.
For more information about the how business orgaizations are taxed, visit these links:
Corporation: Philippines - Corporate - Taxes on corporate income (pwc.com)
Individuals: Philippines - Individual - Taxes on personal income (pwc.com)

Depreciation - is the method of systematically allocating the cost of a capital asset over time for financial reporting, tax
reasons, or both. Depreciation charges are treated as cost items on a company's tax return. As a result, depreciation reduces
taxable income. If all other factors are equal, the higher the depreciation costs, the smaller the tax.

Straight Line Method: StraightLine Depreciation - Formula & Guide to Calculate Depreciation
(corporatefinanceinstitute.com)
Double Declining Balance Method: Double Declining Balance (DDB) Depreciation Method Definition
(investopedia.com)

Note: example discussion in Depreciation wil be given and presented separately.

Interest Expense versus Dividends Paid

Interest paid on active corporate debt is deductible as a business expenditure. Dividends given to preferential or common
investors, on the other hand, are not tax free. As a result, including debt (e.g., bonds) in the financing mix of a profitable,
tax-paying firm results in a considerable tax benefit as compared to preferred or ordinary stock. Given a marginal tax rate
of 25 percent, a firm that pays out P1 in interest lowers its tax bill by 25 cents because of its ability to deduct the P1 of
interest from taxable income. The after-tax cost of P1 of interest for this firm is really only 75 cents – P1 x (1 − tax rate).
On the other hand, the after-tax cost of P1 of dividends paid by the firm is still P1 – there is no tax advantage here.
Therefore there are tax advantages associated with using debt financing that are simply not present with either preferred or
common stock financing.

Dividend Income
It is possible for a corporation to possess shares in another corporation. If it receives a cash dividend on this stock, it is
usually tax-free for 70% of the dividend. The tax regulations enable companies (not individuals) to take use of this tax
break to assist mitigate the impact of multiple taxation of the same earnings. The remaining 30% is subject to the corporate
income tax. Only 3,000 monies of dividend income is taxed by a company that earns 10,000 in dividend revenue. If the
whole dividend income was classified as taxable income, taxes would be 1,050 at a marginal tax rate of 35%, instead 3,500
at a marginal tax rate of 35%.

THE FINANCIAL ENVIRONMENT

All companies work in some way inside the financial system, which is made up of a variety of institutions and
marketplaces that serve businesses, individuals, and governments. A company has direct interaction with financial markets
when it invests momentarily idle cash in marketable securities. More importantly, most businesses rely on financial
markets to fund their asset purchases. In the end, whether a business is a success or a failure is determined by the market
price of its securities. While businesses compete in product markets, they must also deal with the financial markets on a
regular basis. Because of the significance of the environment to the finite finite finite finite finite finite finite finite finite

The Purpose of Financial Markets

Financial assets arise in an economy because different people, businesses, and governments save different amounts of
money over time than they invest in actual assets. Houses, buildings, equipment, inventories, and durable items are
examples of real assets. There would be no external finance, financial assets, or money or capital markets if savings
matched investment in real assets for all economic units in an economy throughout all time periods. Each monetary unit
would be self-contained. Current expenses and real estate investments would be paid for using current revenue. Only if an
economic unit invests in real estate does it become a financial asset.
The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users. If those economic units
that saved were the same as those that engaged in capital formation, an economy could prosper without financial markets.
In modern economies, however, most nonfinancial corporations use more than their total savings for investing in real
assets. Most households, on the other hand, have total savings in excess of total investment. Efficiency entails bringing the
ultimate investor in real assets and the ultimate saver together at the least possible cost and inconvenience.

Financial Markets
Financial markets are more like systems for directing savings to the final investors in real assets than they are actual sites.

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FM 101: Financial Management Module 2: The Business, Tax, and Financial Environment

Money and Capital Markets. The money market and the capital market are the two types of financial markets. The
money market is involved with the buying and selling of short-term government and corporate debt instruments having
initial maturities of less than one year. The capital market, on the other hand, deals with debt and equity securities having a
relatively lengthy initial maturity (more than one year) (e.g., bonds and stocks).

Primary and Secondary Markets. There are main and secondary markets in money and capital markets. A main market
is a market for “new issues.” Here, monies earned via the sale of new securities are transferred from ultimate savers to
ultimate real-estate investors. Existing securities are purchased and sold on a secondary market. Transactions in these
already-existing securities do not generate additional cash for capital investment.

Financial Intermediaries
Financial intermediaries Commercial banks, savings institutions, insurance firms, pension funds, financing businesses,
and mutual funds are examples of financial institutions. By converting direct claims into indirect claims, these
intermediaries act as a link between final borrowers and lenders. Financial intermediaries buy direct (or primary) securities
and then sell them to the public as indirect (or secondary) securities. A mortgage, for example, is a direct security
purchased by a savings and loan organization, whereas a savings account or a certificate of deposit is an indirect claim
granted. A life insurance business, on the other hand, buys corporate bonds and offers life insurance policies, among other
things.

Financial intermediation is the practice of saving depositing cash with financial intermediaries (rather than purchasing
stocks and bonds directly) and allowing the intermediaries to lend to the final investors. Financial intermediation is
commonly thought to improve market efficiency by decreasing the cost and/or inconvenience of financial services to
customers.

Deposit Institutions. In general, commercial banks are the most important source of money for businesses. Individuals,
businesses, and governments provide banks with demand (checking) and time (savings) deposits, which they use to create
loans and investments. Seasonal and other short-term loans, intermediate-term loans of up to five years, and mortgage
loans are among the loans given to businesses. Commercial banks have an impact on businesses through their trust
departments, which invest in company bonds and stocks in addition to providing banking functions. They also provide
mortgage loans to businesses and handle pension funds. Savings and lending associations, as well as cooperative savings
and loan associations, are other deposit-taking organizations.

Insurance Companies. Property and casualty insurance businesses and life insurance companies are the two categories of
insurance firms. These companies receive money from those they cover on a regular basis in exchange for paying payouts
in the case of unforeseen catastrophes. Insurance companies develop reserves using the money they receive in premium
payments. These reserves, as well as a portion of the capital of the insurance firms, are invested in financial assets.

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FM 101: Financial Management Module 2: The Business, Tax, and Financial Environment

Fires, thefts, vehicle accidents, and other calamities are covered by property and casualty insurance. Because these
businesses pay the full corporate income tax rate, they put a lot of money into municipal bonds, which yield tax-free
interest.

Other Financial Intermediaries. Individuals set up pension accounts and other retirement funds to provide income when
they retire. Employees and employers both contribute to these funds during their working lifetimes. These payments are
invested, and the funds either pay out the accumulated sums to retired workers on a regular basis or arrange annuities.
Money deposited into a fund is not taxed during the accumulation period. When payments are handed out in retirement,
the beneficiary is responsible for paying taxes. Commercial banks and insurance firms, as well as the federal government,
municipal governments, and a few other non-insurance institutions, offer pension funds through their trust departments.
Because of the nature of the project, it will take a long time to complete.

Financial Brokers
Investment Bankers - are intermediaries who help companies sell their stocks and bonds.
Mortgage Bankers - are involved in the purchase and placement of mortgages.

The Secondary Markets

The seamless operation of the financial system is aided by a variety of security exchanges and marketplaces. The
secondary market is where existing financial assets are bought and sold. The development of a functioning secondary
market boosts the liquidity of financial assets and hence strengthens the primary or direct market for securities.
Transactions in this market do not increase the overall quantity of financial assets outstanding. In this sense, established
exchanges, such as the Philippine Stock Exchange, provide a mechanism for effectively matching buy and sell orders. The
dynamics of supply and demand decide the pricing in this match.

Allocation of Funds and Interest Rates

In a market economy, money is allocated largely on the basis of price, which is represented in terms of projected return.
For their usage, economic entities in need of cash must outbid others. Although capital rationing, government limitations,
and institutional constraints influence the allocation process, anticipated return is the fundamental mechanism by which
supply and demand for a given financial instrument are brought into balance throughout financial markets. If risk is
constant, economic units that are prepared to pay the highest projected return have the right to utilize money. If individuals
are sensible, the economic units with the highest bids will have the best investment opportunities.
It is important to recognize that the process by which savings are allocated in an economy occurs not only on the basis of
expected return but on the basis of risk as well. The degree of risk associated with various financial products varies. These
products must produce various projected returns, or yields, in order to compete for funding.
Assuming markets were in balance, all securities would give the same anticipated returns if their risk profiles were
identical. Various instruments, however, offer varied degrees of risk and give different projected returns to the investor due
to variances in default risk, marketability, maturity, taxability, and embedded options.

Default Risk. When we talk about default risk, we're talking about the possibility that the borrower would miss payments
on principle or interest. To invest in securities that are not default-free, investors seek a risk premium (or additional
projected return). The bigger the danger of default for the borrower, the higher the default risk and the premium sought by
the market. Because Treasury securities are typically thought to be default-free, risk and return are measured in terms of
them. The larger a security issuer's default risk, the higher the expected return or yield of the asset, all other factors being
equal.

Marketability. The capacity of a security's owner to convert it into cash is measured by its marketability (or liquidity).
Marketability has two dimensions: the price achieved and the length of time it takes to sell the item. Both are connected in
that it is frequently feasible to sell an asset in a short period of time provided a sufficient price concession is made.
Marketability is measured in terms of the ability to sell a large number of securities in a short period of time without
having to make substantial price concessions. The better the potential to perform a significant transaction around the
advertised price, the more marketable the asset. In general, the lesser a security's marketability, the worse it is.

Maturity. Even though securities have a comparable default risk, marketability, and are not subject to differing tax
consequences, they might trade at different yields. Why? The answer is "time." The maturity of an asset has a significant
impact on the projected return, or yield. The term structure of interest rates is the connection between yield and maturity
for securities that differ solely in the length of time (or term) until maturity. A yield curve is a graphical depiction of this
connection at a certain point in time.

Taxability. The unequal impact of taxes is another element influencing the observed variations in market yields. Income
tax is the most significant tax, and it is the only one we shall discuss here. To taxable investors, interest income on all but
one kind of assets is taxable. Interest earned on state and local government bonds is tax-free. As a result, state and local
bonds have lower yields to maturity than Treasury and corporate bonds with the same term. Interest income on Treasury
securities is tax-free for firms situated in states that have income taxes.

Option Features. Another factor to examine is if a security has any option features, such as a conversion privilege or
warrants, that allow an investor to receive common shares upon exercise. Other possibilities include the call feature, which
allows a corporation to prepay its debt, and a sinking-fund provision, which allows a company to retire bonds with cash
payments or by purchasing them in the secondary market on a regular basis. The issuing firm should be able to borrow at a
reduced interest rate if the investors are given alternatives. Investors must be paid with a greater yield if the issuing firm
obtains an option, such as a call feature.

LEARNING POINTS
● The three basic forms of business organization are the sole proprietorship, the partnership, and the corporation.

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FM 101: Financial Management Module 2: The Business, Tax, and Financial Environment

● The corporation has emerged as the most important organizational form owing to certain advantages that it has
over the other organizational forms. These advantages include limited liability, easy transfer of ownership,
unlimited life, and an ability to raise large sums of capital.
● Most firms with taxable income prefer to use an accelerated depreciation method for tax reporting purposes in
order to lower their taxes. A firm that is profitable for financial reporting purposes may, in fact, show losses for
tax purposes.
● Interest paid by corporations is considered a taxdeductible expense; however, dividends paid are not tax
deductible.
● Financial assets (securities) exist in an economy because an economic unit’s investment in real assets (such as
buildings and equipment) frequently differs from its savings. In the economy as a whole, savings surplus units
(those whose savings exceed their investment in real assets) provide funds to savings-deficit units (those whose
investments in real assets exceed their savings). This exchange of funds is evidenced by investment instruments,
or securities, representing financial assets to the holders and financial liabilities to the issuers.
● The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users.
● Financial intermediaries help make the financial markets more efficient. Intermediaries come between ultimate
borrowers and lenders by transforming direct claims into indirect claims. Financial intermediaries purchase direct
(or primary) securities and, in turn, issue their own indirect (or secondary) securities to the public.
● Financial brokers, such as investment bankers and mortgage bankers, bring together parties who need funds with
those who have savings. These brokers are not performing a direct lending function but rather are acting as
matchmakers, or middlemen.
● Financial markets can be broken into two classes – the money market and the capital market. The money market is
concerned with the buying and selling of short-term government and corporate debt securities. The capital market
deals with relatively long-term debt and equity instruments.
● l Within the money and capital markets there exist both primary and secondary markets. A primary market is a
“new issues” market, and a secondary market is a “used issues” market.
● l The secondary market for long-term securities, comprising the organized exchanges and the OTC market,
increases the liquidity (marketability) of financial assets, and therefore enhances the primary market for long-term
securities.
● l The allocation of savings in an economy occurs primarily on the basis of expected return and risk.
● l Differences in default risk, marketability, maturity, taxability, and option features affect the yield of one security
relative to another at a point in time. Fluctuations in supply and demand pressures in financial markets, as well as
changing inflation expectations, help explain variability in yields over time.

LEARNING ACTIVITIES

1. John Henry has a small housecleaning business that currently is a sole proprietorship. The business has nine employees,
annual sales of 480,000, total liabilities of 90,000, and total assets of 263,000. Including the business, Henry has a personal
net worth of 467,000 and nonbusiness liabilities of 42,000, represented by a mortgage on his home. He would like to give
one of his employees, Tori Kobayashi, an equity interest in the business. Henry is considering either the partnership form
or the corporate form, where Kobayashi would be
given some stock. Kobayashi has a personal net worth of 36,000.
a. What is the extent of Henry’s exposure under the sole proprietorship in the case of a large lawsuit (say, 600,000)?
b. What is his exposure under a partnership form? Do the partners share the risk?
c. What is his exposure under the corporate form?
2. Bernstein Tractor Company has just invested in new equipment costing 16,000. The equipment falls in the five-year
property class for cost recovery (depreciation) purposes. What depreciation charges can it claim on the asset for each of the
next six years?
3. Wallopalooza Financial, Inc., believes that it can successfully “intermediate” in the mortgage market. At present,
borrowers pay 7 percent on adjustable rate mortgages. The deposit interest rate necessary to attract funds to lend is 3
percent, also adjustable with market conditions. Wallopalooza’s administrative expenses, including information costs, are 2
million per annum on a base business of $100 million in loans.
a. What interest rates on mortgage loans and on deposits would you recommend to obtain business?
b. If 100 million in loans and an equal amount of deposits are attracted with a mortgage rate of 6.5 percent and a deposit
interest rate of 3.5 percent, what would be Wallopalooza’s annual before-tax profit on the new business? (Assume that
interest rates do not change.)
4. Suppose that 91-day Treasury bills currently yield 6 percent to maturity and that 25-year Treasury bonds yield 7.25
percent. Lopez Pharmaceutical Company recently has issued long-term, 25-year bonds that yield 9 percent to maturity.
a. If the yield on Treasury bills is taken to be the short-term, risk-free rate, what premium in yield is required for the
default risk and lower marketability associated with the Lopez bonds?
b. What premium in yield above the short-term, risk-free rate is attributable to maturity?

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