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Basic Characteristics of Equity
One person may operate a business as the sole proprietor and
provide all the equity capital of the business. A sole propri-
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

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separate entity or person in the eyes of the law. The general
partners of the business can be held responsible for the liabili-
ties 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 gen-
eral 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 man-
agement of the business.

Most businesses, even relatively small ones, favor the corpo-
rate form of organization. A corporation is a legal entity sepa-
rate from its individual owners. A corporation is a legal entity
that shields the personal assets of the owners (the stockhold-
ers, 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 lit-
erally 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 busi-
nesses. However, more than 860,000 businesses corporations
had annual sales revenue over $1 million.

Other countries around the globe have the equivalent of cor-
porations, 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 cre-
ation of a new type of business legal entity called a limited lia-
bility company (LLC). This innovative business entity is a
hybrid between a partnership and a corporation; it has char-
acteristics 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

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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 inter-
est. Equity capital does not. Nevertheless, equity capital has
an imputed or implicit cost. Management must earn a satis-
factory 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 addi-
tional equity capital (if and when needed). In extreme circum-
stances, 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 stock-
holders.
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 divi-
dends. And the market value of the equity shares has no theo-
retical 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 addi-
tional 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

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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% =
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 mar-
ketable 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, depend-
ing 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)

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interest rate, and (3) return on equity (ROE). Figure 6.2 illus-
trates 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 differ-
ent 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 exam-
ined 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
$ 900,000 · equity $ 6,000,000 = 15.0% equity (ROE)
Net income
FIGURE 6.2 Rates of return on assets, debt, and equity.


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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 corpo-
ration). 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, govern-
ment provides what can be called public capital. Government
provides public facilities (highways, parks, schools, etc.), politi-
cal 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

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$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
$900,000 net income
= = $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

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