Lecturer 3
- 1. LECTURE# 3 Business Organizations Taxation Time Value of Money
- 2. Business Organizations Three Types Sole Proprietorship (Business owned by one person) Partnership (a legal agreement b/w two or more person) Corporations (a legal entity created by state)
- 4. Taxes Taxes are major outflows which reduces your income. There are certain rules and regulations for calculating Taxes.
- 5. Corporate Federal Income Tax Rates
- 6. Corporate Taxes Basically there are four basic rates: 15%, 25%, 34%, and 35% 38% and 39% are the “Bubble Rate” Bubble rates have effect of taking away benefit of lower rates from the high income corporation.
- 7. Corporate Taxes and Tax Rates
- 8. Tax Terms Marginal Tax Rate: Amount of tax payable on the next dollar earned. Average Tax Rate (Effective Tax Rate): Total taxes paid divided by the taxable income
- 9. Tax Terms (Cont.) Ordinary taxable income = Ordinary Gross Income – Deductable Expenses Ordinary Gross Income = Sales Revenue + Other Income ( Other income includes Dividends, and Interest Income )
- 10. Tax Terms (Cont.) Interest Income Interest income received by the corporation is taxes at ordinary rate Dividend Income Dividend income received by the corporation is subjected to tax break. The size of the dividend exclusion is depended on the degree of firm’s ownership in other dividend paying firm.
- 11. Tax Terms (Cont.) Dividend Income Corporations that own less than 20 percent of the stock of the dividend-paying company can exclude 70 percent of the dividends received; Firms that own more than 20 percent but less than 80 percent can exclude 80 percent of the dividends; and Firms that own more than 80 percent can exclude the entire dividend payment. We will, in general, assume a 70 percent dividend exclusion.
- 12. Tax Terms (Cont.) Deductable Expense Include s Cash Deductable Expense Cost of Goods Sold Selling Expense General & Administrative Lease Payment Interest Paid Non- Cash Deductable Expense Depreciation Amortization Depletion Allowance (Deductable only for tax purpose but do not involve actual outlay of cash)
- 13. Interest and Dividend income received by a Corporation Example: If a corporation has earning more than $18,333,333 and paying a 35% marginal tax rate, at what tax rate this firm will pay for its dividend income? Ans: 10.5%
- 14. Interest and Dividend income received by a Corporation Example: If this firm had $10,000 in pre-tax dividend income, what would be its after-tax dividend income. Ans: $ 8,950.
- 15. Interest and Dividend income received by a Corporation Triple Taxation Organization is first taxed Again it is taxed for dividend income Individual shareholders
- 16. Interest and Dividend income received by a Corporation Example: GE had $100,000 to invest, and it could buy either bonds that paid interest of $8,000 per year or preferred stock that paid dividends of $7,000. GE is in the 35 percent tax bracket; find after tax income on both bond and stock investment. Ans: $ 5,200 (Bonds), and $ 735 (Stock) Higher after tax income with investment in stock suggests that it favors stock investments when the investor is a corporation.
- 17. Cash Deductable Expense Interest and dividend paid by the organization The interest paid by a corporation (debt financing) is deducted from its operating income to obtain its taxable income, Dividends paid (equity financing)are not deductible.
- 19. Cash Deductable Expense Since the fact, that interest is a deductible expense and has a profound effect on the way businesses are financed. Our corporate tax system favors debt financing over equity financing.
- 20. Non-Cash Deductable Expense Depreciation: The systematic allocation of the cost of an asset over time. It is an operating cost. Depreciation expense is not an actual outlay, but deducted for tax purposes. Greater the depreciation, lower the firm’s profit, hence lowering the taxable income. Depreciation Rate : The annual %age rate at which an asset is depreciated or its cost is recovered. Depreciable Base: Cost of Asset plus all costs related its purchase
- 21. Non-Cash Deductable Expense Depreciation: Methods of Calculating Depreciation: Straight-Line Method
- 23. Non-Cash Deductable Expense Depreciation: Modified ACRS Method (Accelerated Cost Recovery System) Depreciation method under U.S Tax Law is categorized depreciable property into the classes.
- 25. Details for MACRS Calculations We developed these recovery allowance percentages based on the 200 percent declining balance method prescribed by MACRS, with a switch to straight-line depreciation at some point in the asset’s life. For example, consider the 5-year recovery allowance percentages. The straight line percentage would be 20 percent per year, so the 200 percent declining balance multiplier is 2.0(20%) 40% 0.4. However, because the half-year convention applies, the MACRS percentage for Year 1 is 20 percent. For Year 2, there is 80 percent of the depreciable basis remaining to be depreciated, so the recovery allowance percentage is 0.40(80%) 32%. In Year 3, 20% 32% 52% of the depreciation has been taken, leaving 48%, so the percentage is 0.4(48%) 19%. In Year 4, the percentage is 0.4(29%) 12%. After 4 years, straight-line depreciation exceeds the declining balance depreciation, so a switch is made to straight-line (this is permitted under the law). However, the half-year convention must also be applied at the end of the class life, and the remaining 17 percent of depreciation must be taken (amortized) over 1.5 years. Thus, the percentage in Year 5 is 17%/1.5 11%, and in Year 6, 17% 11% 6%. Although the tax tables carry the allowance percentages out to two decimal places, we have rounded to the nearest whole number for ease of illustration.
- 26. MACRS Illustration Examples: Consider an automobile costing $12,000 . Autos are normally classified as five-year property . Calculate its yearly depreciation using MACRS. The Staple Supply Co. has just purchased a new computerized information system with an installed cost of $160,000 . The computer is treated as five-year property . What are the yearly depreciation allowances ? Based on historical experience, we think that the system will be worth only $10,000 when Staple gets rid of it in four years. What are the tax consequences of the sale? What is the total after-tax cash flow from the sale?
- 27. Depreciation Which Depreciation method Firms Consider Straight-Line Method for financial statements Accelerated Methods for Income Tax Return
- 28. Corporate Loss Carry-Back and Carry-Forward All operating losses are carried back to each 2 preceding years. All operating Losses are carry forwarded to the following 20 years. Losses are that are carried back are deducted from first from earlier years and then brought forward on year by year basis until either the loss is offset or given time is exhausted. (Old books write 2 years for Carry-Back and 15 years for Carry forward)
- 29. Corporate Loss Carry-Back and Carry-Forward Example: Simpsons Plastic, Inc. had a $ 300,000 operating loss in 1987. The firm’s taxable income and tax paid form 1984 to 1988 is below. Determine loss carry-back and carry forward?
- 30. Corporate Capital Gain (Loss) Capital Gain (Loss) result from the sale of capital assets. Capital Asset : An asset that is not bought or sold in ordinary course of business. Capital Gain will be taxes at ordinary rates . Capital Loss will be deducted in full from Ordinary Income.
- 31. Corporate Capital Gain (Loss) For Example: Capital Gain = $ 5,000 Capital Loss = $ 2,000 Result Capital Gain = $ 3,000 (taxed at ordinary rate) For Example: Capital Gain = $ 2,000 Capital Loss = $ 5,000 Result Capital Loss = $ 3,000 (deducted from ordinary income)
- 32. Problems 1. The Bradley Co. had $325,000 in 2007 taxable income. Using the rates from Table, calculate the company’s 2007 income taxes. 2. Corporation Growth has $82,000 in taxable income, and Corporation Income has $8,200,000 in taxable income. a. What is the tax bill for each firm? b. Suppose both firms have identified a new project that will increase taxable income by $10,000. How much in additional taxes will each firm pay? Why is this amount the same?
- 33. Time Value of Money Definition: The price put on the time an investor has to wait until a project matures. The time value of money is the most important concept used in finance , also called discounted cash flow (DCF) analysis. Time Line: It is a graphical representation used to show the timing of cash flows.
- 34. Time Value of Money Future Value (FV) The amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate.
- 35. Time Value of Money Present Value (PV) The value today of a future cash flow or series of cash flows.
- 36. Time Value of Money
- 37. Time Value of Money Compounding (PV) The arithmetic process of determining the final value of a cash flow or series of cash flows when compound interest is applied. Discounting (FV) The process of finding the present value of a cash flow or a series of cash flows; discounting is the reverse of compounding.
- 38. Time Value of Money Annuity (Stream of equal payment) A series of payments of an equal amount at fixed intervals for a specified number of periods. Future Value Of An Annuity
- 39. Time Value of Money Present Value Of An Annuity
- 40. Time Value of Money Problems For each of the following compute the future value .
- 41. Time Value of Money Problems For each of the following compute the Present Value .
- 42. Time Value of Money Problems For each of the following solve for unknown interest rate.
- 43. Time Value of Money Problems For each of the following solve for unknown number of years.