DBA/ S-III/ Financial Management

FINANCIAL MANAGEMENT

CHAPTER 2

The Business, Tax, and Financial Environments

Fundamentals of Financial Management

From the Studied Slides….

The Business, Tax, and Financial Environments

The Business Environment

The Tax Environment

The Financial Environment

The Business Environment

Summary for Sole Proprietorship

Advantages

Simplicity

Low setup cost

Quick setup

Single tax filing on individual form

Disadvantages

Unlimited liability

Hard to raise additional capital

Transfer of ownership difficulties

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.

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.

Summary for Partnership

Advantages

Can be simple

Low setup cost, higher than sole proprietorship

Relatively quick setup

Limited liability for limited partners

Disadvantages

Unlimited liability for the general partner

Difficult to raise additional capital, but easier than sole proprietorship

Transfer of ownership difficulties

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.

Summary for Corporation

Advantages

Limited liability

Easy transfer of ownership

Unlimited life

Easier to raise large quantities of capital

Disadvantages

Double taxation

More difficult to establish

More expensive to set up and maintain

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.

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

Summary for LLC

Advantages

Limited liability

Eliminates double taxation

No restriction on number or type of owners

Easier to raise additional capital

Disadvantages

Limited life (generally)

Transfer of ownership difficulties (generally)

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.

Common Types of Depreciation

Straight-line (SL)

Accelerated Types

Double-Declining-Balance (DDB)

Modified Accelerated Cost Recovery System (MACRS)

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 users.

Chapter 3

Time Value of Money

The Time Value of Money

The Interest Rate

Simple Interest

Compound Interest

The Interest Rate

Which would you prefer -- $10,000 today or $10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is TIME VALUE TO MONEY!!

Why TIME?

Why is TIME such an important element in your decision?

TIME allows you the opportunity to postpone consumption and earn INTEREST.

Types of Interest

Simple Interest

Interest paid (earned) on only the original amount, or principal borrowed (lent).

Compound Interest

Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

Simple Interest Formula

SI = P0(i)(n)

SI:        Simple Interest

P0:       Deposit today (t=0)

i:          Interest Rate per Period

n:         Number of Time Periods

Simple Interest Example

Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years.  What is the accumulated interest at the end of the 2nd year?

SI = P0(i)(n)= $1,000(.07)(2)= $140

Simple Interest (FV)

What is the Future Value (FV) of the deposit?

FV = P0 + SI = $1,000 + $140= $1,140

Future Value: Is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

Simple Interest (PV)

What is the Present Value (PV) of the previous problem?

The Present Value is simply the $1,000 you originally deposited. That is the value today!

Present Value: is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.                       
Single Deposit (Graphic)

Assume that you deposit $1,000 at a compound interest rate of 7% for 2 years.

Single Deposit (Formula)

FV1 = P0 (1+i)1 = $1,000 (1.07)= $1,070

Compound Interest

You earned $70 interest on your $1,000 deposit over the first year.

This is the same amount of interest you would earn under simple interest.

Future Value

Single Deposit (Formula)

FV1= P0 (1+i)1 = $1,000 (1.07)= $1,070

FV2= FV1 (1+i)1 = P0 (1+i)(1+i) = $1,000(1.07)(1.07)

= P0 (1+i)2= $1,000(1.07)2= $1,144.90

You earned an EXTRA $4.90 in Year 2 with compound over simple interest.

General Future Value Formula

FV1= P0(1+i)1 , FV2       = P0(1+i)2

General Future Value Formula:

FVn       = P0 (1+i)n  or  FVn = P0 (FVIFi,n)

FV1 = P0(1+i)1 , FV2 = P0(1+i)2

Story Problem Example

Julie Miller wants to know how large her deposit of $10,000 today will become at a compound annual interest rate of 10% for 5 years.

Story Problem Solution

Calculation based on general formula:

FVn = P0 (1+i)n ,FV5            = $10,000 (1+ 0.10)5= $16,105.10

Present Value

Assume that you need $1,000 in 2 years.  Let’s examine the process to determine how much you need to deposit today at a discount rate of 7% compounded annually.

Present Value            
Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 = FV2 / (1+i)2 = $873.44

General Present Value Formula

PV0 = FV1 / (1+i)1 , PV0 = FV2 / (1+i)2

General Present Value Formula:

PV0= FVn / (1+i)n  or  PV0 = FVn (PVIFi,n)

Types of Annuities

An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

Ordinary Annuity:  Payments or receipts occur at the end of each period.

Annuity Due:  Payments or receipts occur at the             beginning of each period.

Examples of Annuities

Student Loan Payments

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

Steps to Solve Time Value of Money Problems

Read problem thoroughly

Determine if it is a PV or FV problem

Create a time line

Put cash flows and arrows on time line

Determine if solution involves a single CF, annuity stream(s), or mixed flow

Solve the problem

Check with financial calculator (optional)

THE END

The U.S. has four basic forms of business organization:

Sole Proprietorships

Partnerships (general and limited)

Corporations

Limited liability companies

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.