FIN 3403 Chapter 1 Notes

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FIN 3403 Chapter 1 Notes  1–5 What are the main types of decisions that financial managers make? o Investments decisions  How the company will spend money on long-term projects that determine whether the firm creates value for its owners  Ex. How much money to spend on new factories  Largely dictates whether a firm will succeed or not  Uses capital budgeting to decide which projects create the most value  Identifies investment opportunities where the benefits exceed costs o Financing decisions (also called capital structure decision) – Determine how companies raise money needed to pursue investment opportunities  Firms just starting out require capital from investors  Capital – Money that firms raise to finance their activities  Can be raised by borrowing money from banks/investors or individuals who want part ownership Making Investment Decisions Making Financing Decisions Current Assets Current Liabilities Fixed Assets Long-Term Funds  Working capital decisions – refers to the management of a firm’s short- term resources  Involves tracking/forecasting firm’s cash position, making sure the bills are paid on time and receiving timely payments, calculating the optimal amount of inventory the firm should have on hand  1–6 Why is it important that managers recognize that a tradeoff exists between risk and return? Why does that tradeoff exist? o Higher risk = higher reward o Principal-agent problem - arises when the owners (principals) and managers (agents) of a firm are not the same people, and the agents fail to act in the interest of the principals

o Treasurer - manages the firm’s cash, investing surplus funds when available and securing outside financing when needed.  Oversees pension plans and works with the DORF o Director of risk management - manages the firm’s cash, investing surplus funds when available and securing outside financing when needed o Controller - centered on accounting, budgeting, and tracking the performance of a business unit o Director of investor relations - conduit of information between the firm and the investment community o Director of internal audit - leads a team that is charged with making sure that all units within the firm are following internal policies and complying with government regulations o Foreign exchange managers – manages and monitors the firm’s exposure to loss from currency fluctuations  1–7 What is the primary economic principle used in managerial finance?

o Marginal cost-benefit analysis – economic principle that states that financial decisions should be made and actions taken only when the marginal benefits exceed marginal costs o Example: Justin currently has a drink dispenser that has made him roughly $73,000 in net cash flow (i.e., revenue minus the cost of operating the machine and providing cups and lids). He can replace this with a Freestyle machine for $20,000 which leads him to believe that he will make an estimated net soft drink cash flow of $100,000 per year. If he buys the new one, he can sell his old one for $5,000. Applying marginal cost-benefit analysis: Net soft drink cash flow w/ new dispenser $100,000 Less: Cash flow w/ old dispenser $73,000 (1) Marginal benefit $100k - $73k = $27,000 Cost of new dispenser $20,000 Less: Proceeds from sale of old dispenser $5,000 (2) Marginal cost $15,000 Net benefit [(1) – (2)] $12,000 Since the marginal benefit of $27,000 exceeds the marginal cost of $15,000 investing in one isn’t a bad decision  1–8 What are the major differences between accounting and finance with respect to emphasis on cash flows and decision-making? o Cash flow - Accounting o Develop and report data to measure the firm’s performance o GAAP – prepares financial statements on an accrual basis recognizing revenues and expenses as they occur  Important rule: firm should report expenses in the same period in which it earns the related revenue o Accrual approach doesn’t give accurate picture of cash flowing in and out of firm  Financial managers emphasis on cash flows

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o Maintain solvency of firm by making sure they have enough cash to pay bills and invest o Uses cash basis to recognize revenues and expenses only when actual inflows and outflows occur  Example: Yacht company sells boat for $1 million at the end of calendar year. The company paid for the yacht over the summer for $800k. They have yet to collect the $1 million dollar from their customer Accounting view (accrual basis) Sales revenue $1 million Less: Costs $800k Net Profit $200k Financial view (cash basis) Cash inflow $0 Less: Cash outflow $800k New cash flow -$800k Personal Finance Example Item Inflow Outflow Rent $4,400 Car payment -$1,200 Utilities -$450 Groceries -$300 Clothes -$800 Dining out -$750 Gas -$650 Interest income -$250 Misc. expense $220 -$425 Totals $4,620 -$4,835 o Decision making – Accounting o Focus on collecting and presenting financial data  Financial Managers – evaluate accounting info and other data 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship to influence business decisions to create value for shareholders Sole proprietorships Partnerships Corporations

Number of firms (millions) 25.3 3.4 5.8 Percentage of all firms 73% 10% 17% Percentage of all business income 10% 26% 64% Strengths and Weaknesses of the Common Legal Forms of Business Organization Sole proprietorships Partnerships Corporations Strengths - Owner receives all profits (and sustains all losses) - Low organizational costs - Income taxed only on proprietor’s personal tax return - Independence - Secrecy - Ease of dissolution - Owners who are limited partners have limited liability and cannot lose more than they invested - Ability to raise funds enhanced by more owners - More available brain power and managerial skill - Income taxed only on partners’ personal tax returns - Owners have limited liability and cannot lose more than they invested - Can achieve large size via sale of ownership (stock) - Ownership (stock) is readily transferable - Long life of firm - Can hire professional managers - Has better access to financing Weaknesses - Owner has unlimited liability in that personal wealth can be taken to satisfy debts - Limited fund- raising power tends to inhibit growth - Owners who are general partners have unlimited liability and may have to cover debts of other partners - Partnership is dissolved when a - The corporation pays taxes, and corporate income is taxed a second time when distributed to shareholders as a dividend - More expensive to organize than other

- Proprietor must be jack-of-all-trades - Difficult to give employees long-run career opportunities - Lacks continuity when proprietor dies partner dies - Difficult to liquidate or transfer partnership business forms - Subject to greater government regulation - Lacks secrecy because regulations require firms to disclose financial results  Table 1.2

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 To use Table 1.2 to calculate a tax liability, simply multiply the tax rate times the amount of income earned in each bracket and then sum across brackets. o Calculatingtax liability for anincomebracket = incometax rate×taxableincome withinthe incomebrac o Totaltax liability = ∑ of tax liability foreachincomebracket  Example 1.5: o Dan is a partner in Webster Manufacturing. This year, Dan’s share of the partnership’s earnings is $80k before taxes. Dan is single and has no other income, the taxes he owes on his business income are: Totaltax liability = ( 0.10 ×$ 9,875 ) +[ 0.12 × ( $ 40,125 − $ 9,785 ) ]+ [ 0.22 × ( $ 80,000 − $ 40,125 ) ] ¿ $ 987.50 + $ 3,630 + $ 8,772.50 ¿ $ 13,390  A common misconception is that taxpayers can be worse off by earning extra income because that puts them in a higher tax bracket. Notice that Webster falls in the 22% income tax bracket (i.e., his business income is greater than $40,125 but less than $85,525), but the 22% rate applies only to income above $40,125. He pays 10% tax on the first $9,875 that he earns and 12% on the next $30,250 of earnings. Only the final $39,875 in earnings is subject to the 22% tax rate o Marginal tax rate – tax rate that applies to the next dollar earned. In Table 1.2 the MTR is 10% if the taxpayer earns less than $9,875. o Average tax rate – average tax rate paid per dollar of taxable income  Averagetax rate = totaltax liability÷taxableincome o Since tax rates change with income levels for many the average tax rate DOES NOT equal the marginal rate  In example 1.5, Dan’s marginal tax rate is 22% but his average tax rate is 16.7% ( $ 13,390 ÷ $ 80,000 ) . As his income grows, the marginal tax rate and average tax rate will rise but the average tax rate will always be lower of the two. Figure 1.3 shows the taxes that Dan would pay, the marginal tax rate, and the average tax rate at four income levels: $80,000, $160,000, $320,000, and $640,000

 Red bars = the amount of tax due in each income bracket  Blue bar = the total tax bill  Moving from one graph to the next, the marginal tax rate and the average tax rate both increase, but the average tax rate is always less than the marginal rate.  Figure 1.4 shows how the marginal and average tax rates vary with taxable income for an individual taxpayer based on the tax rates and income brackets in Table 1.2 . Marginal tax rates increases each time taxable income crosses into the next higher tax bracket, but average tax rates rise more gradually.

o Most business decisions the marginal tax rate is what matters the most  Managers create value for shareholders by choosing the option which marginal benefits exceed the marginal costs  Managers focus on marginal tax rates because it determines the marginal taxes that they will pay o Double taxation – Situation facing corporations in which income from the business is taxed twice – once at business level and once at the individual level when cash is distributed to shareholders  Previously, corporations faced progressive structure similar to the one that determined individuals’ taxes, the top marginal rate in that structure was 35%  This rate applied to any business with taxable income over $18.3 million, so large corporations generally fell under the 35% rate  Tax Cuts and Jobs Act of 201 replaces old corporate tax with a flat tax of 21% o Example 1.6:  Peter is the sole proprietor of Argaiv Software and earned a taxable income of $300,000. Assuming this is his only source of income and that

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he’s single, from Table 1.2 we can see that based on Peter’s tax bracket, he faces a marginal tax rate of 35%. How much tax does Peter owe?  Totaltax liability = ( 0.10 ×$ 9,875 ) + [ 0.12 × ( $ 40,125 − $ 9,875 ) ] + [ 0.22 × ( $ 85,525 − $ 40,125 ) ] + [ 0.24 × ( 163,300 − $ 85,525 ) ] + [ 0.32 × ( $ 207,350 − $ 163,300 ) ] + [ 0.35 × ( $ 300,000 − $ 207,350 ) ] ¿ $ 987.50 + $ 3,630 + $ 9,988 + $ 18,666 + $ 14,096 + $ 32,427.50 ¿ $ 79,795  If Argaiv is organized as a corporation and not a sole proprietorship the company would pay 21% corporate tax rate on the $300,000 earnings. That means Argaiv will pay $ 63,000 ( 0.21 ×$ 300,000 ) in taxes and will have $237,000 in after-tax income which will pay Peter as a dividend.  Based on his $237,000 income level Peter will pay 15% capital gain tax on the dividend income plus he will pay 3.8% net investment tax on the portion of his investment income that exceeds $200,000 o Personal liability tax = $ 36,956 [ 0.15 ×$ 237,000 + 0.038 × ( $ 237,000 − $ 200,00  Adding up the taxes paid by Argaiv and its owner we can see the effect of the double taxation o Totaltax liability = $ 63,000 + $ 39,956 = $ 99,956  In this case, the company and its owner pay a combined tax bill of $99,956, whereas the total tax bill on $300,000 of business income was $79,795 as a sole proprietorship o Ordinary income – achieved through sale of goods or services o Capital gain – occurs if a firm sells an asset for more than it costs  For individuals, these types of incomes are treated differently for taxation purposes but NOT for corporations  Corporations must add capital gains to ordinary income when calculating taxes o Dividends received get a tax break  Depends on how large of an ownership stake the corporation receiving dividends holds in the

corporation paying them but generally its 50 % or more of the dividends received  Eliminates the potential tax liability from dividends received by corporation and moderates the effect of double taxation o When calculating taxes, corporations can deduct operating expenses as well as interest expenses they pay to lenders  This reduces their after-tax cost o Example 1.7: o Two corporations, Debt Co. and No-Debt Co., earned $200,000 before interest and taxes this year. During the year, Debt Co. paid $30,000 in interest. No-Debt Co. had no debt and no interest expense. How do the after-tax earnings of these firms compare? Both firms face a 21% flat tax rate. Debt Co. had $30,000 more interest expense than No-Debt Co., but Debt Co.’s earnings after taxes are only $23,700 less than those of No-Debt Co. This difference is attributable to Debt Co.’s $30,000 interest expense deduction, which provides a tax savings of $6,300 (the tax bill is $35,700 for Debt Co. versus $42,000 for No-Debt Co.). The tax savings can be calculated directly by multiplying the 21% tax rate by the interest expense . Similarly, the $23,700 after-tax interest expense can be calculated directly by multiplying one minus the tax rate by the interest expense. Why should the investment decision be separate from the financing decision? What error would businesses make if they

did not separate these type of decisions? Why is it sometimes difficult to separate these decision? Investment decisions are made to yield the most profit for a company in the long run. An example of this would be a local restaurant purchasing a Coca-Cola Freestyle machine to encourage customers to buy more sodas. Financing decisions are the actions that the business takes to acquire the funds to do so. In this example, the restaurant could either sell equity or take on additional debt in the form of a loan (“ Introducing Finance ,” n.d.). Although these two decisions coincide with one another, they should be separated when determining if a project is worth pursuing. When deciding if something should be invested in, the company needs to consider all of the costs within the purchase. For a restaurant that is looking to purchase a new drink dispenser, some examples of these costs are paper cups, lids, and electricity. At the start of the project, these additions will be a significant expense and may not be the best the most viable action to take. Once it is determined to be a profitable decision, the company can then decide what financial steps would be the most appropriate to take (“ Separation of Investing and Financing Decisions,” n.d.). If these two decisions are not separated, a company could stunt its growth due to the fear of spending a significant amount of money upfront. This makes isolating investment from financial decisions difficult because they often overlap with one another, and new businesses are scared of falling even more into debt. Works Cited Introducing finance: Types of financial decisions: Investment and financing . Saylor Academy. (n.d.). https://learn.saylor.org/mod/book/view.php? id=53636&chapterid=37589#:~:text=Investment%20decisions%20revolve%20around %20how,%2C%20borrow%2C%20or%20sell%20equity. MSG Management Study Guide . Separation of Investing and Financing Decisions. (n.d.). https://www.managementstudyguide.com/separation-of-investing-and-financing- decisions.htm

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FIN 3403 Chapter 1 Notes

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