Prentice Hall's one-day MBA in finance & accounting (14 page)

etorship
business is not a separate legal entity; it’s an exten-

sion of the individual. Many businesses are legally organized as a
partnership
of two or more persons. A partnership is a
84

Team-Fly®

B U S I N E S S C A P I T A L S O U R C E S

separate entity or person in the eyes of the law. The general partners of the business can be held responsible for the liabilities of the partnership. Creditors can reach beyond the assets of the partnership to the personal assets of the individual partners to satisfy their claims against the business. The general partners have
unlimited liability
for the liabilities of the partnership. Some partnerships have two classes of partners—general and limited. Limited partners escape the unlimited liability of general partners but they have no voice in the management of the business.

Most businesses, even relatively small ones, favor the corporate form of organization. A
corporation
is a legal entity separate from its individual owners. A corporation is a legal entity that shields the personal assets of the owners (the stockholders, or shareowners) from the creditors of the business. A business may deliberately defraud its creditors and attempt to abuse the limited liability of corporate shareowners. In this case the law will “pierce the corporate veil” and hold the guilty individuals responsible for the debts of the business.

The corporate form is a practical way to collect a pool of equity capital from a large number of investors. There are literally millions of corporations in the American economy. In 1997 the Internal Revenue Service received over 4.7 million tax returns from business corporations. Most were small businesses. However, more than 860,000 businesses corporations had annual sales revenue over $1 million.

Other countries around the globe have the equivalent of corporations, although the names of these organizations as well as their legal and political features differ from country to country. A recent development in the United States is the creation of a new type of business legal entity called a
limited liability company
(LLC). This innovative business entity is a hybrid between a partnership and a corporation; it has characteristics of both. Most states have passed laws enabling the creation of LLCs.

Corporations issue
capital stock shares;
these are the units of equity ownership in the business. A corporation may issue only one class of stock shares, called
common stock
or
capital
stock.
Or a corporation may issue both
preferred stock
and common stock shares. Preferred stock shares are promised an
85

A S S E T S A N D S O U R C E S O F C A P I T A L

annual cash dividend per share. (The actual payment of the dividend is contingent on the corporation earning enough net income and having enough cash on hand to pay the dividend.) A corporation may issue both voting and nonvoting classes of stock shares. Some corporations issue two classes of voting shares that have different voting power per share (e.g., one class may have ten votes per share and the other only one vote per share).

Debt bears an explicit and legally contracted rate of interest. Equity capital does not. Nevertheless, equity capital has an imputed or implicit cost. Management must earn a satisfactory rate of earnings on the equity capital of the business to justify the use of this capital. Failure to do so reduces the value of the equity and makes it more difficult to attract additional equity capital (if and when needed). In extreme circumstances, the majority of stockholders could vote to dissolve the corporation and force the business to liquidate its assets, pay off its liabilities, and distribute the remainder to the stockholders.

The equity shareholders in a business (the stockholders of DANGER!

a corporation) take the risk of business failure and poor performance. On the optimistic side, the shareowners have no limit on their participation in the success of the business.

Continued growth can lead to continued growth in cash dividends. And the market value of the equity shares has no theoretical upper limit. The lower limit of market value is zero (the shares become worthless)—although corporate stock shares could be
assessable,
which means the corporation has the right to assess shareholders and make them contribute additional capital to the organization. Almost all corporate stock shares are issued as nonassessable shares, although equity investors in a business can’t be too careful about this.

RETURN ON INVESTMENT

I was a stockholder in a privately owned business a few years ago. I owned 1,000 shares of common stock in the business and served on its board of directors. One thing really hit home.

I came to appreciate firsthand that we (the stockholders) had a lot of money invested, and we expected the business to do well with our money. We could have invested our money elsewhere and received interest income or earned some other type of
86

B U S I N E S S C A P I T A L S O U R C E S

return on our alternative investment. Management was very much aware that their responsibility was to improve the value of our stock shares over time, which would require that the business earn a good return on our investment.

The basic measure for evaluating the performance

of capital investments is the
return on investment
(ROI), which always is expressed as a percent. To calculate ROI, the amount of return is divided by the amount of capital invested:

return

ROI% = ᎏᎏ

capital invested

ROI is always for a given period of time—one year unless clearly stated otherwise.
Return
is a generic term and means different things for different investments. For investments in marketable securities, return includes cash income received during the period and the increase or decrease in market value during the period. The ROI on an investment in marketable securities is negative if the decrease in market value is more than the cash income received during the period.

Market value is not a factor for some investments. One example is an investment in a certificate of deposit (CD) issued by a financial institution. Return equals just the interest earned. A CD is not traded in a public market place and has no market value. The value of a CD is the amount the financial institution will redeem it for at the maturity date, which is the face value on which interest is based. In the event that the financial institution doesn’t redeem the CD at full value at maturity, the investor suffers a loss that could wipe out part or all of the interest earned on the CD. (CDs are guaranteed up to a certain limit by an agency of the federal government, but that’s another matter.)

Real estate investments may or may not include market value appreciation in accounting for annual earnings, depending on whether market prices of the real estate properties can be reliably estimated or appraised at the end of each period. If market value changes are not booked, the return on a real estate investment venture is not known until the conclusion of the investment project.

Evaluating the investment performance of a business uses three different measures: (1)
return on assets
(ROA), (2)
87

A S S E T S A N D S O U R C E S O F C A P I T A L

interest rate,
and (3)
return on equity
(ROE). Figure 6.2 illustrates the calculations of these three key rates of return for the business introduced earlier. The example assumes that the business has $4 million debt capital and $6 million equity capital. (Different mixes of debt and equity capital are examined later.) The definitions for each rate of return are as follows:

• ROA = earnings before interest and income tax expenses, or EBIT ÷ (assets − operating liabilities)

• Interest rate = interest expense ÷ interest bearing debt

• ROE = net income ÷ owners’ equity

Figure 6.2 is a
capital structure model
that can be used to analyze alternative scenarios such as a different debt-to-equity ratio, a higher or lower ROA performance, or a different interest rate. Figure 6.2 is the printout of a relatively simple personal computer worksheet. Different numbers can easily be plugged into the appropriate cell for one or more of the variables in the model in order to see how net income and the ROE would be affected. Alternative scenarios are examined later in the chapter using the capital structure model.

Sales revenue less all operating expenses equals
earnings
before interest and income tax
(EBIT). As shown in Figure 6.2, EBIT is divided three ways: (1)
interest
on debt capital, (2)
income tax,
keeping in mind that interest is deductible to Earnings before

Assets less

Return on

interest and

operating

assets

income tax (EBIT) $1,800,000 ÷ liabilities $10,000,000 = 18.0% (ROA) Interest expense ($ 300,000) ÷ Debt

$ 4,000,000 = 7.5% Interest rate

Income tax

expense @

40% of taxable

income

($ 600,000)

Government

Owners’

Return on

Net income

$ 900,000 ÷ equity

$ 6,000,000 = 15.0% equity (ROE)

FIGURE 6.2
Rates of return on assets, debt, and equity.

88

B U S I N E S S C A P I T A L S O U R C E S

determine taxable income, and (3) residual
net income.
In other words, the debt holders get a chunk of EBIT (interest), the federal and state governments get their chunks (income tax), and what’s left over is profit for the shareowners of the business (net income). Note that the ROA rate and the interest rate are
before
income tax, whereas ROE is
after
income tax.

The income tax factor is in the middle of things in more ways than one.

PIVOTAL ROLE OF INCOME TAX

In a world without income taxes, EBIT would be

divided between the two capital sources—interest on debt and net income for the equity owners (the stockholders of a corporation). But in the real world income tax takes a big bite out of earnings after interest. In the example, the combined federal and state income tax rate is set at 40 percent of taxable income. As you probably know, interest expense is deducted from EBIT to determine taxable income ($1.8 million EBIT −

$300,000 interest = $1.5 million taxable income; $1.5 million taxable income × 40% combined federal and state income tax rate = $600,000 income tax).

The following question might be asked: Should income tax be considered a return on government capital investment? The federal and state governments do not directly invest capital in a business, of course. In a broader sense, however, government provides what can be called
public capital.
Government provides public facilities (highways, parks, schools, etc.), political stability, the monetary system, the legal system, and police protection. In short, government provides the necessary infra-structure for carrying on business activity, and government funds this through income taxes and other taxes.

Under the federal income tax law (U.S. Internal Revenue Code), interest on debt is deductible in determining annual taxable income. Cash dividends paid to stockholders—which can be viewed as the equity equivalent of interest on debt—are
not
deductible in determining taxable income. This basic differentiation in the tax law has significant impact on the amount of EBIT needed to earn a satisfactory ROE on the equity capital of a business.

The business in the example needs to earn just $300,000

EBIT for its $300,000 interest. The $300,000 EBIT minus
89

A S S E T S A N D S O U R C E S O F C A P I T A L

$300,000 interest leaves zero taxable income and thus no income tax. In contrast, to earn $900,000
after-tax
net income on equity, the business needs $1.5 million EBIT: $900,000 net income

ᎏᎏᎏ = $900,000

ᎏᎏ = $1,500,000 EBIT

1 − 40% income tax rate

0.60

Income tax takes $600,000 of the $1,500,000 earnings after interest, leaving $900,000 net income after income tax.

Suppose for the moment that interest were not deductible to determine taxable income. In this imaginary income tax world the business would need $500,000 EBIT to cover its $300,000 interest. Income tax at the 40 percent rate would be $200,000 on this $500,000 EBIT, leaving $300,000 after tax to pay interest. The business would need $500,000 EBIT for interest and $1.5 million EBIT for net income, for a total of $2

Notes on Income Tax

TThe company example uses a 40 percent combined federal and state income tax rate, which is realistic. However, the taxation of business income varies considerably from state to state. Also, under the current federal income tax law, corporate taxable income from $335,000 to $10 million is taxed at a 34 percent rate. Annual taxable incomes below $335,000 are taxed at lower rates and above $10 million at a slightly higher rate. The example assumes that the business is a corporation and is taxed as a domestic C (or regular) corporation.

A corporation with 75 or fewer stockholders may elect to be treated as an S corporation. An S corporation pays no income tax itself; its annual taxable income is passed through to its individual stockholders in proportion to their ownership share.

Sole proprietorships, partnerships, and limited liability companies are also tax con-duits; they are not subject to income tax as separate entities but pass their taxable income through to their owner or owners who have to include their shares of the entity’s taxable income in their personal income tax returns. Individual situations vary widely, as you know.

Corporations may have net loss carryforwards that reduce or eliminate taxable income in one year. There is also the alternative minimum tax (AMT) to consider, to say nothing of a myriad of other provisions and options (loopholes) in the tax law. It’s very difficult to generalize. The main point is that in a given year in a given situation the taxable income of the business may not result in a normal amount of income tax.