the business,tex,and financial environments

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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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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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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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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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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

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RM

ED

IAR

IES

SAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

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FIN

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CIA

LIN

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RM

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IAR

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SAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

INVESTMENTINVESTMENTSECTORSECTOR

Businesses

Government

Households

INVESTMENT INVESTMENT SECTORSECTOR

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FIN

AN

CIA

LIN

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RM

ED

IAR

IES

SAVINGS SECTORSAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

SAVINGSSAVINGSSECTORSECTOR

Households

Businesses

Government

INVESTMENT SECTOR

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FIN

AN

CIA

LIN

TE

RM

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IAR

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SAVINGS SECTOR

FINANCIAL BROKERSFINANCIAL BROKERS

SECONDARY MARKET

FINANCIALFINANCIALBROKERSBROKERS

Investment Bankers

Mortgage Bankers

INVESTMENT SECTOR

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FIN

AN

CIA

LF

INA

NC

IAL

INT

ER

ME

DIA

RIE

SIN

TE

RM

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IAR

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SAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

FINANCIALFINANCIALINTERMEDIARIESINTERMEDIARIES

Commercial BanksSavings Institutions

Insurance Cos.Pension Funds

Finance CompaniesMutual Funds

INVESTMENT SECTOR

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FIN

AN

CIA

LIN

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RM

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IAR

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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.

the business,tex,and financial environments

Economy & Finance

business form

business income

tax environment

limited partnership

limited liability company

tax purposes

quick setup limited

personal liability