SCHAUM’S OUTLINE OF

FINANCIAL
MANAGEMENT
Third Edition

JAE K. SHIM, Ph.D.
Professor of Business Administration
California State University at Long Beach

JOEL G. SIEGEL, Ph.D., CPA
Professor of Finance and Accounting
Queens College
City University of New York



SCHAUM’S OUTLINE SERIES

New York Chicago San Francisco Lisbon London Madrid
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Copyright © 2007, 1998, 1986 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America.
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1.

Definitions and explanations that are clear and concise.

2.

Examples that illustrate the concepts and techniques discussed in
each chapter.
3. Review questions and answers.
4.

Detailed solutions to representative problems covering the subject matter.

5.

Comprehensive examinations, with solutions, to test the student’s
knowledge of each chapter; the exams are representative of those
used by 2- and 4-year colleges and M.B.A. programs.

In line with the development of the subject, two professional designations
are noted. One is the Certificate in Management Accounting (CMA)/Certified
in Financial Management (CFM) which is a recognized certificate for both
management accountants and financial managers. The other is the Chartered
Financial Analyst (CFA), established by the Institute of Chartered Financial
Analysts. Students who hope to be certified by either of these organizations
may find this outline particularly useful.
This book was written with the following objectives in mind:
1.

To supplement formal training in financial management courses


Chapter

1

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8

Chapter

Chapter

Chapter

Chapter

2

3

4

5

2.6
2.7
2.8
2.9
2.10

The Scope and Purpose of Financial Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financial Statement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Horizontal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Vertical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary and Limitations of Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Sustainable Rate of Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Economic Value Added (EvaÕ ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash Basis of Preparing the Statement of Changes in Financial Position . . . . . . . . . . . .
The Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17
17
18
21
22
34
35
35
37
38

FINANCIAL FORECASTING, PLANNING, AND BUDGETING . . . . . . . . . . . . .


4.4
4.5

Managing Net Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Management of Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

100
101
101
107
112

SHORT-TERM FINANCING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

133

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2 Trade Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3 Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.4 Bankers’ Acceptances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.5 Commercial Finance Company Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.6 Commercial Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.7 Receivable Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

133
133
134

6

7

8

9

Chapter 10

TIME VALUE OF MONEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

160

6.1
6.2
6.3
6.4

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Future Values – Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Present Value – Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Applications of Future Values and Present Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

160
160
162
163

RISK, RETURN, AND VALUATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8.9
8.10
8.11

Capital Budgeting Decisions Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Measuring Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital Budgeting Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mutually Exclusive Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Modified Internal Rate of Return (MIRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing Projects with Unequal Lives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Concept of Abandonment Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
How Does Income Taxes Affect Investment Decisions? . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital Budgeting Decisions and the Modified Accelerated
Cost Recovery System (MACRS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.12 Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.13 Capital Budgeting and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

205
205
207
212
213
214
215
216
216
217


10.2
10.3
10.4

282
282
285
287

Cost of Capital Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Computing Individual Costs of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Measuring the Overall Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Level of Financing and the Marginal Cost of Capital (MCC) . . . . . . . . . . . . . . . . . . . . . .

218
221
223


CONTENTS

Chapter 11

vii

LEVERAGE AND CAPITAL STRUCTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

306

11.1


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Factors that Influence Dividend Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stock Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stock Split . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stock Repurchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

337
338
339
340
340
341

TERM LOANS AND LEASING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

349

13.1
13.2
13.3
13.4

Intermediate-Term Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Insurance Company Term Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

349

15.1
15.2
15.3
15.4
15.5
15.6
15.7
15.8
15.9
15.10
15.11

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Public Versus Private Placement of Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Going Public – About an Initial Public Offering (IPO) . . . . . . . . . . . . . . . . . . . . . . . . . . .
Venture Capital Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stock Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ Equity Section of the Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Governmental Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

372
372
373
373
373
374

16.2
16.3
16.4
16.5
16.6
16.7

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Convertible Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Black–Scholes Option Pricing Model (OPM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Management and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

401
401
403
406
409
410
411

MERGERS AND ACQUISITIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

418

17.1
17.2
17.3

18.2
18.3
18.4
18.5

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Voluntary Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bankruptcy Reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liquidation Due to Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Z Score Model: Forecasting Business Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

435
435
437
439
444

MULTINATIONAL FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

454

19.1
19.2
19.3
19.4
19.5
19.6
19.7
19.8
19.9

Appendix
Appendix
Appendix

..................................................................................
..................................................................................
..................................................................................
..................................................................................
..................................................................................

476
477
478
479
480

INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

481

17.6
17.7
17.8
17.9

Chapter 18

Chapter 19

A

of information technology—are providing exciting challenges in terms of increased profitability and
new risks.
Profit Maximization versus Stockholder Wealth Maximization
Profit maximization is basically a single-period or, at the most, a short-term goal. It is
usually interpreted to mean the maximization of profits within a given period of time. A firm
may maximize its short-term profits at the expense of its long-term profitability and still realize
this goal. In contrast, stockholder wealth maximization is a long-term goal, since stockholders
are interested in future as well as present profits. Wealth maximization is generally preferred
because it considers (1) wealth for the long term; (2) risk or uncertainty; (3) the timing of returns;
and (4) the stockholders’ return. Table 1-1 provides a summary of the advantages and disadvantages
of these two often conflicting goals.

Table 1-1.
Goal

Profit Maximization versus Stockholder Wealth Maximization
Objective

Advantages

Disadvantages

Profit
maximization

Large amount
of profits

1. Easy to calculate
profits

1. Offers no
clear relationship between
financial decisions
and stock price
2. Can lead to
management anxiety
and frustration
3. Can promote aggressive
and creative accounting
practices

1
Copyright © 2007, 1998, 1986 by The McGraw-Hill Companies, Inc. Click here for terms of use.


2

INTRODUCTION

[CHAP. 1

EXAMPLE 1.1 Profit maximization can be achieved in the short term at the expense of the long-term goal,
that is, wealth maximization. For example, a costly investment may experience losses in the short term but
yield substantial profits in the long term. Also, a firm that wants to show a short-term profit may, for
example, postpone major repairs or replacement, although such postponement is likely to hurt its long-term
profitability.
EXAMPLE 1.2 Profit maximization does not consider risk or uncertainty, whereas wealth maximization
does. Consider two products, A and B, and their projected earnings over the next 5 years, as shown below.

Year

comparatively greater level of risk.

1.2

THE ROLE OF FINANCIAL MANAGERS

The financial manager of a firm plays an important role in the company’s goals, policies, and
financial success. The financial manager’s responsibilities include:
1. Financial analysis and planning: Determining the proper amount of funds to employ in the firm,
i.e., designating the size of the firm and its rate of growth
2. Investment decisions: The efficient allocation of funds to specific assets
3. Financing and capital structure decisions: Raising funds on as favorable terms as possible, i.e.,
determining the composition of liabilities
4. Management of financial resources (such as working capital)
5. Risk management: protecting assets by buying insurance or by hedging.
In a large firm, these financial responsibilities are carried out by the treasurer, controller,
and financial vice president (chief financial officer). The treasurer is responsible for managing
corporate assets and liabilities, planning the finances, budgeting capital, financing the business,
formulating credit policy, and managing the investment portfolio. He or she basically handles
external financing matters. The controller is basically concerned with internal matters, namely,
financial and cost accounting, taxes, budgeting, and control functions. The chief financial
officer (CFO) supervises all phases of financial activity and serves as the financial adviser to
the board of directors.
The Financial Executives Institute (www.fei.org), an association of corporate treasurers and
controllers, distinguishes their functions as shown in Table 1-2. (For a typical organization chart
highlighting the structure of financial activity within a firm, see Problem 1.4.)


CHAP. 1]



2.
3.

The timing, duration, and risk of these earnings
Dividend policy

4.

The manner of financing the firm

AGENCY PROBLEMS

An agency relationship exists when one or more persons (called principals) employ one or more
other persons (called agents) to perform some tasks. Primary agency relationships exist (1) between
shareholders and managers and (2) between creditors and shareholders. They are the major source of
agency problems.
Shareholders versus Managers
The agency problem arises when a manager owns less than 100 percent of the company’s ownership.
As a result of the separation between the managers and owners, managers may make decisions
that are not in line with the goal of maximizing stockholder wealth. For example, they may work
less eagerly and benefit themselves in terms of salary and perks. The costs associated with the
agency problem, such as a reduced stock price and various ‘‘perks,’’ is called agency costs.
Several mechanisms are used to ensure that managers act in the best interests of the shareholders:
(1) golden parachutes or severance contracts; (2) performance-based stock option plans; (3) the threat
of firing; and (4) the threat of takeover.
Creditors versus Shareholders
Conflicts develop if (1) managers, acting in the interest of shareholders, take on projects with greater
risk than creditors anticipated and (2) raise the debt level higher than was expected. These actions tend to
reduce the value of the debt outstanding.

BASIC FORMS OF BUSINESS ORGANIZATION

Finance is applicable both to all economic entities such as business firms and nonprofit organizations such as schools, governments, hospitals, churches, and so on. However, this book will focus
on finance for business firms organized as three basic forms of business organizations. These forms
are (1) the sole proprietorship; (2) the partnership; and (3) the corporation.
Sole Proprietorship
This is a business owned by one individual. Of the three forms of business organizations, sole
proprietorships are the greatest in number. The advantages of this form are:
1. No formal charter required
2. Less regulation and red tape
3. Significant tax savings
4. Minimal organizational costs
5. Profits and control not shared with others
The disadvantages are:
1. Limited ability to raise large sums of money
2. Unlimited liability for the owner
3. Limited to the life of the owner
4. No tax deductions for personal and employees’ health, life, or disability insurance

Partnership
This is similar to the sole proprietorship except that the business has more than one owner. Its
advantages are:
1. Minimal organizational effort and costs
2. Less governmental regulations
Its disadvantages are:
1. Unlimited liability for the individual partners
2. Limited ability to raise large sums of money
3. Dissolved upon the death or withdrawal of any of the partners




2.
3.

Limited liability for its owners, as long as no personal guarantee on a business-related obligation
such as a bank loan or lease
Ease of transfer of ownership through transfer of stock

4.

Ability to raise large sums of capital

Its disadvantages are:
1.

Difficult and costly to establish, as a formal charter is required

2.

Subject to double taxation on its earnings and dividends paid to stockholders

3.

Bankruptcy, even at the corporate level, does not discharge tax obligations

Subchapter S Corporation
This is a form of corporation whose stockholders are taxed as partners. To qualify as an S
corporation, the following is necessary:
1.
2.


1.6

[CHAP. 1

General flow of funds among financial institutions and financial markets

THE FINANCIAL INSTITUTIONS AND MARKETS

A healthy economy depends heavily on efficient transfer of funds from savers to individuals,
businesses, and governments who need capital. Most transfers occur through specialized financial
institutions (see Fig. 1-1), which serve as intermediaries between suppliers and users of funds.
It is in the financial markets that entities demanding funds are brought together with those having
surplus funds. Financial markets provide a mechanism through which the financial manager may obtain
funds from a wide range of sources, including financial institutions. The financial markets are composed
of money markets and capital markets. Figure 1-1 depicts the general flow of funds among financial
institutions and markets.
Money markets are the markets for short-term (less than 1 year) debt securities. Examples of money
market securities include U.S. Treasury bills, federal agency securities, bankers’ acceptances, commercial
paper, and negotiable certificates of deposit issued by government, business, and financial institutions.
Capital markets are the markets for long-term debt and corporate stocks. The New York Stock
Exchange, which handles the stocks of many of the larger corporations, is a prime example of a capital
market. The American Stock Exchange and the regional stock exchanges are still another example.
In addition, securities are traded through the thousands of brokers and dealers on the over-the-counter
market, a term used to denote all buying and selling activities in securities that do not take place on an
organized stock exchange.
1.7

CORPORATE TAX STRUCTURE


39%
34%
35%
38%
35%

on
on
on
on
on
on
on
on

the
the
the
the
the
the
the
the

first $50,000
next $25,000
next $25,000
next $235,000
next $9,665,000
next $5,000,000

Taxes ($)
7,500
6,250
8,500
91,650
3,286,100
1,750,000
1,266,667
583,333
7,000,000

Financial managers often refer to the federal tax rate imposed on the next dollar of income as the
‘‘marginal tax rate’’ of the taxpayer. Because of the fluctuations in the corporate tax rates, financial
managers also talk in terms of the ‘‘average tax rate’’ of a corporation. Average tax rates are computed
as follows:
Average Tax Rate ¼ Tax Due=Taxable Income
EXAMPLE 1.6 The average tax rate for the corporation in Example 1.5 is 35 percent (7,000,000/20,000,000).
The marginal tax rate for the corporation in Example 1.5 is 35 percent.

As suggested in Example 1.6, at taxable incomes beyond $18,333,333, corporations pay a tax of
35 percent on all of their taxable income. This fact demonstrates the reasoning behind the patch-quilt of
corporate tax rates. The 15 percent–25 percent–34 percent tax brackets demonstrate the intent that there
should be a graduated tax rate for small corporate taxpayers. The effect of the 39 percent tax bracket is
to wipe out the early low tax brackets. At $335,000 of corporate income, the cumulative income tax is
$113,900, which results in an average tax rate of 34 percent ($113,900/$335,000). The income tax rate
increases to 35 percent at taxable incomes of $10,000,000. The purpose of the 38 percent tax bracket is to
wipe out the effect of the 34 percent tax bracket and to raise the average tax rate to 35 percent. This is


8


EXAMPLE 1.7 ABC Corporation owns 2 percent of the outstanding of XYZ Corporation, and ABC Corporation
receives dividends of $10,000 in a given year from XYZ Corporation. As a result of these dividends, ABC
Corporation will have ordinary income of $10,000 and an offsetting dividends received deduction of $7,000 (70
percent  $10,000), which results in a net $3,000 being subject to federal income tax. If ABC Corporation is in the 35
percent marginal tax bracket, its tax liability on the dividends is $1,050 (35 percent  $3,000). As a result of the
dividends received deduction, these dividends are taxed at an effective federal tax rate of 10.5 percent.

Interest and Dividends Paid
Interest paid is a tax-deductible business expense. Thus, interest is paid with before-tax dollars.
Dividends on stock (common and preferred), however, are not deductible and are therefore paid with
after-tax dollars. This means that our tax system favors debt financing over equity financing.
EXAMPLE 1.8 Yukon Corporation has an operating income of $200,000, pays interest charges of $50,000, and
pays dividends of $40,000. The company’s taxable income is:
$200,000
À 50,000
$150,000

(Operating income)
(interest charge, which is tax-deductible)
(taxable income)

The tax liability, as calculated in Example 1.5, is $48,750. Note that dividends are paid with after-tax dollars.

Operating Loss Carryback and Carryforward
If a company has an operating loss, the loss may be applied against income in other years. The loss
can be carried back 2 years and then forward for 20 years. The corporate taxpayer may elect to first
apply the loss against the taxable income in the 2 prior years. If the loss is not completely absorbed by the
profits in these 2 years, it may be carried forward to each of the 20 following years. At the time, any loss
remaining may no longer be used as a tax deduction. To illustrate a 2005 operating loss may be used to

100,000
(700,000)
100,000
100,000
100,000
100,000
100,000

22,250
22,250
0
22,250
22,250
22,250
22,250
22,250

In 2005, Loyla Company had an operating loss of $700,000. By carrying the loss back 2 years and then forward,
the firm was able to ‘‘zero-out’’ its before-tax income as follows:
Year

Income
Reduction ($)

Remaining 2005 Net
Operating Loss ($)

Tax Savings ($)

2003

22,250
22,250
22,250
22,250

As soon as the company recognized the loss of $700,000 in 2005, it was able to file for a tax refund of $44,500
($22,250 + $22,250) for the years 2003 through 2004. It then carried forward the portion of the loss not used to
offset past income and applied it against income for the next 5 years, 2006 through 2010.

Capital Gains and Losses
Capital gains and losses are a major form of corporate income and loss (see also Chapter 8). They
may result when a corporation sells investments and/or business property (not inventory). If depreciation
has been taken on the asset sold, then part or all of the gain from the sale may be taxed as ordinary
income.
Like all taxpayers, corporations net any capital gains and capital losses that they have. Corporations
include any net capital gains as part of their taxable income. Individuals pay tax on their capital gains at
reduced rates.
Modified Accelerated Cost Recovery System (MACRS)
For all assets acquired after 1986, depreciation for tax purposes (‘‘cost recovery’’) is calculated
using the Modified Accelerated Cost Recovery System (‘‘MACRS’’). MACRS is discussed in depth in
Chapter 8.
Alternative ‘‘Pass-Through’’ Tax Entities
As noted above, a disadvantage of corporations, compared to other forms of doing business (e.g.,
general partnerships), is double taxation. The net income of a corporation is taxed to the corporation.
Later, should the corporation distribute that income to its shareholders, the distribution is taxed a


10

INTRODUCTION

(0)
$100,000
(28,000)
$ 72,000

Double taxation costs the investor $16,020 or approximately 16 percent in the above example. This
percentage increases as the corporation’s marginal tax rate increases.
Generally, the pass-through entity merely files an informational tax return with the Internal Revenue
Service, and informs its owners of their share of the entity’s taxable income or loss. The owners will be
taxed on their share of the corporation’s income. Afterwards, the distribution of any accrued income to
the owners generally is tax-free.
1.8

THE SARBANES–OXLEY ACT AND CORPORATE GOVERNANCE

Section 404 of the Sarbanes–Oxley Act—‘‘Enhanced Financial Disclosures, Management
Assessment of Internal Control’’—mandates sweeping changes. Section 404, in conjunction with the
related Securities and Exchange Commission (SEC) rules and Auditing Standard No. 2 established by
the Public Company Accounting Oversight Board (PCAOB), requires management of a public company
and the company’s independent auditor to issue two new reports at the end of every fiscal year. These
reports must be included in the company’s annual report filed with the SEC.


Management must report annually on the effectiveness of the company’s internal control over
financial reporting.



In conjunction with the audit of the company’s financial statements, the company’s independent
auditor must issue a report on internal control over financial reporting, which includes both an

2.
stockholders.

3. A firm’s stock price depends on such factors as present and future earnings per share, the
of these earnings, and
.
timing, duration, and
4. A major disadvantage of the corporation is the
paid to its owners (stockholders).
the

on its earnings and

is the largest form of business organization with respect to the number of
5. A
such businesses in existence. However, the corporate form is the most important with respect to
, assets,
, and contribution
the total amount of
.
to
6. A corporation is a(n)
.
as

that exists separately from its owners, better known

7. A partnership is dissolved upon the
.
the


The
is the term used for all trading activities in securities that do not take
place on an organized stock exchange.

13.

Commercial banks and credit unions are two examples of

.

.

14.

represent the distribution of earnings to the stockholders of a corporation.

15.

are the rates applicable for the next dollar of taxable income.

16.

In order to avoid triple taxation, corporations may be entitled to deduct a portion of
that they receive.
the

17.

If a corporation has a net operating loss, the loss may be

21.

Risk
by

22.

management

involves

protecting

assets

by

years and/or

purchasing

or

.

Under the
company’s

Act, management must report annually on the effectiveness of the
.

SOLUTION
The financial manager performs the following functions:
1.

Financial analysis, forecasting, and planning
(a) Monitors the firm’s financial position
(b) Determines the proper amount of funds to employ in the firm
2. Investment decisions
(a) Makes efficient allocations of funds to specific assets
(b) Makes long-term capital budget and expenditure decisions


CHAP. 1]

INTRODUCTION

13

Fig. 1-2

3.

Financing and capital structure decisions
(a) Determines both the mix of short-term and long-term financing and equity/debt financing
(b) Raises funds on the most favorable terms possible
4. Management of financial resources
(a) Manages working capital
(b) Maintains optimal level of investment in each of the current assets

1.3

percent.

1.6

Tax Liability. A corporation has $120,000 in taxable income. What is its tax liability?


14

INTRODUCTION

[CHAP. 1

SOLUTION
Income ($) Â Marginal Tax Rate (%) = Taxes ($)
50,000
25,000
25,000
20,000
120,000

15
25
34
39

7,500
6,250
8,500
7,800

(10,000)
$212,500

(operating income)
(interest income)
(dividend income)
(100% dividend received deduction for 100% subsidiary)
(taxable income)

The company’s total tax liability is computed as follows:
Income ($) Â Marginal Tax Rate (%) = Taxes ($)
50,000
25,000
25,000
112,500
212,500

1.10

15
25
34
39

7,500
6,250
8,500
43,875
66,125


2,500
10,000

Note that since dividends of $20,000 are paid out of after-tax income, the dividend amount is not
included in the computation.

1.11

Net Operating Loss Carryback and Carryforward. The Kenneth Parks Company’s taxable
income and tax payments/liability for the years 2003 through 2008 are given below.
Year

Taxable Income ($)

Tax Payments ($)

2003
2004
2005
2006
2007
2008

100,000
50,000
(150,000)
100,000
50,000
50,000


22,250
7,500
29,750

As soon as the corporation recognizes the $150,000 loss in 2005, it may file for a tax refund of $29,750
($7,500 + $22,250) for the years 2003 and 2004.

1.12

Net Operating Loss Carryback and Carryforward. Assume that the Kenneth Parks Company
anticipates that corporate tax rates will decline in future years, and, therefore, elects to forgo
the carryback and to instead carry the net operating loss forward. Calculate the company’s tax
benefit in the future years assuming no change in tax rates.
SOLUTION
Year

Income
Reduction ($)

Remaining 2005 Net
Operating Loss ($)

Tax Savings ($)

2006
2007
Total

100,000
50,000