Business Organizations and the Tax Environment Chapter 6

Alternative Forms of Business Organization • Sole Proprietorship - unincorporated business owned by one individual • Partnership - unincorporated business owned by two or more persons • LLC : Limited liability company, general partners and limited partners.

• Corporation - legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability • corporate charter is filed with the state providing information about the company and directors • bylaws are for internal management and procedures

Finance in the Organizational Structure of the Firm Corporation Org-Chart

Board of Directors President Credit Manager VP Marketing VP Finance (CFO) VP Manufacturing Treasurer Controller Inventory Manager Director of Capital Budgeting Cost Accounting Financial Accounting Tax Department

The Goals of the Corporation

• Stockholder wealth maximization • considers the risk and timing associated with expected earnings per share in order to maximize the price of the firm’s common stock • • • Managerial incentives to maximize shareholder wealth Social responsibility Stock price maximization and social welfare • Profit Maximization • Will profit maximization also result in stock price maximization?

• Consider: • total corporate profit versus earnings per share (EPS) • timing of earnings • • risk of project risk of financing • dividend payout versus reinvestment

Agency Relationships

• Owner/principal hires an agent and delegates decision making authority to that agent to act on behalf of the principal • Agency problem exists when conflict of interest between principal and agent • between stockholders and managers • between stockholders and creditors

Stockholders versus Managers

• The threat of firing • The threat of hostile takeover • due to underpriced stock • may be warded off with poison pill or greenmail • Structuring management incentives • executive stock options • performance shares

Stockholders versus Creditors

• Creditors lend based on expectations • riskiness of the firms existing assets • • expectations concerning the riskiness of future asset additions the firm’s existing capital structure • expectations concerning future capital structure changes (amount of debt) • Stakeholders must be treated fairly

Factors Affecting Stock Prices The External Environment • Legal constraints • General level of economic activity • Tax laws • Conditions in the stock market

Factors Affecting Stock Prices External Constraints • Antitrust laws • Environmental regulations • Product and workplace safety regulations • Employment practice rules • Federal reserve policy • International developments

Factors Affecting Stock Prices Strategic Policy Decisions Controlled by Management • Types of product or services produced • Production methods used • Relative use of debt financing • Dividend policy

Factors Affecting Stock Prices Level of Economic Activity and Corporate Taxes •

Expected profitability

•

Timing of cash flows

•

Degree of risk

•

Stock Market Conditions ( Stock Price)

Business Ethics

• Company’s attitude and conduct toward its stakeholders (employees, customers, stockholders…) • Ethical behavior requires fair and honest treatment toward all parties • Avoids fines and legal expenses • Builds public trust • Attracts business from customers who appreciate and support the firm’s policies • Attracts and keeps employees of the highest caliber • Supports the economic viability of the communities in which it operates

Multinational Corporations

• Operate in more than one country • To seek new markets • To seek raw materials • To seek new technology • To seek production efficiency • To avoid political and regulatory hurdles

Multinational versus Domestic Managerial Finance • Different currency denominations • Economic and legal ramifications • Language differences • Cultural differences • Role of governments • Political risk

The Federal Income Tax System

Individual Income Taxes Business Income Taxes

Individual Income Taxes

• Progressive tax: higher tax on higher incomes • Taxable income is gross income minus exemptions and allowable deductions • Marginal tax rate is the tax on the last unit of income • Average tax rate is taxes paid divided by taxable income

Taxes On Dividend and Interest Income • Dividends are paid out of earnings that have already been taxed • Interest on most state and local government bonds (municipals) is not subject to federal income taxes

Comparing Yields Tax-free and Taxable Equivalent pre-tax yield on a taxable investment = Yield on tax-free investment 1 - Marginal tax rate

A taxpayer in the 30% marginal tax bracket who could buy a municipal bond that yields 10 % would have to receive a before-tax yield of 14.3% on a corporate or US Treasury bond to have the same after-tax yield.

 1 10%  0.30

 14.3%

Individual Income Taxes

• Interest paid by individuals is generally not deductible, with the exception of mortgage interest • Capital gains versus ordinary income • profit from sale of capital asset • benefits of long-term capital gains • Business versus personal expenses

Corporate Income Taxes

• Interest and dividend income received by a corporation • 70% of dividends received by another corporation is excluded from taxable income • Interest and dividends paid by a corporation • interest is deducted from income

Corporate Income Taxes

• Corporate capital gains • currently taxed at same rate • Corporate loss carryback and carryover • losses can be carried back 2 years and carried over to the next 20 years • Accumulated earnings tax • Consolidated corporate tax returns • if own 80% or more • S Corporations • small corporation that elects to be taxed as a proprietorship or partnership yet retains limited liability and other benefits of incorporating

Corporate Tax Rates in Other Countries Tax Rate

I. Developed Markets

Australia Canada France Germany Italy Japan Netherlands Switzerland United Kingdom United States

Tax Rate

36.0% 44.6 36.7 57.4/44.1 53.2 51.6 35.0 28.5 31.0 40.0

Corporate Tax Rates in Other Countries • Tax Rate

II. Emerging Markets Tax Rate

Brazil 25.0

Chile China, PR 15.0

33.0

India Indonesia Korea 35.0

30.0

30.8

Malaysia Mexico Philippines Thailand 30.0

34.0

35.0

30.0

Corporate Tax Rates in Other Countries • 15 Countries with No Income Taxes Monaco Kuwait Bermuda U.A.E.

Andorra British Virgin Islands Qatar Bahamas Oman Brunei Cayman Islands Anguilla Maldives Turks and Caicos Vanuatu