Chapter 10 Financing Ongoing Operations and Tax Planning

							       Chapter 10: Financing Ongoing Operations and Tax Planning

                                           Outline



I.   Introduction

     A. Firms Need Capital for

         1. Finance ongoing operations

         2. Take advantage of unexpected opportunities

         3. Fulfill longer-run strategic plans

     B. Cash Position Reflect Firm’s Performance

         1. Low levels of cash – a sign of weak or risky firm

         2. High levels of cash – health firm

     C. Sources to Generate Cash

         1. Operating Earnings

         2. Sale of operating assets

         3. Sale of investments

         4. Short-term borrowing

         5. Accelerating, factoring, or selling receivables

         6. Decrease in dividends

         7. Payment of stock dividends instead of cash dividends

         8. Stock buybacks

         9. Employee stock option plans

         10. Receipt of dividends from subsidiaries
 II.   Operating Earnings

       A. Operating Earnings – Add to Retained Earnings

       B. Excess Retained Earnings Subject to U.S. accumulated Earnings Tax



III.   Sale of Operating Assets

       A. Sale of Operating Assets Result in Gain or Loss

          1. Gain/loss calculation

              Gain/loss = Proceed from sales – Adjusted basis of assets

              Adjusted basis = Original cost + improvement – accumulated depreciation

          2. Gain

              a. Some jurisdictions do not tax on the gain of selling operating assets

              b. Some jurisdictions tax on the gain

                 i.    The gains are treated as capital gain and taxed as ordinary income

                 ii.   Capital gains can be offset by capital losses

          3. Loss

              Losses from selling operating assets are ordinary ones and fully deductible.

       B. Tax Benefit of Depreciation Taken (Example 10.1)

       C. Negotiate with Buyers to Adjust Payment Timing



IV.    Sale of Investments

       A. Sale of Investments Generates Capital Gain or Loss

          1. Tax treatment of capital gain or loss for corporations

              a. Capital gains are taxed as ordinary income
            b. Capital losses can offset capital gain; net capital losses can be carried

                     backward and forward

               i.       Three years backward

               ii.      Five years forward; after five years, the remaining net loss expired

        2. Tax treatment of capital gain or loss for individuals

            a. Capital gains are taxed at lower capital gain rate

            b. Capital losses are netted with capital gains

               i.       Annual net capital losses deductible amount is $3,000

               ii.      Remaining net losses can be carried forward indefinitely

     B. Different Impact of Capital Gain/Loss between Sale of Operating Assets and

        Investments

        1. Unrealized capital gain/loss did not recognize for operating assets

        2. Unrealized capital gain/loss must be recognized for investment (Example

            10.2)



V.   Short-Term Borrowing

     A. Cash Flows from Borrowing Are Not Taxable

     B. Interest on Borrowing Are Tax Deductible

        1. Short-term borrowing’s interest rate is higher than long-term borrowing

        2. Short-term borrowing is not subject to the violation of debt covenants

        3. Transaction costs should be capitalized and amortized over the borrowing

            period (Example 10.3 and 10.4)
VI.    Accounts Receivable

       A. Early Payment Takes Advantage of Discount But with No Tax Effect

       B. Selling and Factoring Accounts Receivables Results in Recognizing A Tax Loss

       C. The Timing of Recognizing the Loss Can Be Designated

       D. The Timing of Write Off Bad Debt Can Be Designated

       E. There Exist Transaction Costs (Example 10.5)



VII.   Decrease in Dividends

       A. Decrease Dividends

          1. Increase firm’s cash flow

          2. Shareholder need not to pay tax when no dividend received

          3. The reinvested capital will hopefully generate more return than dividend

       B. Transform (Example 10.6)

          1. Individuals

              Transform periodical ordinary income – dividend to one-time capital gain

          2. Institutional investors

              They prefer dividends because of the dividend received tax deduction and

              income tax exemption status

          3. Tax-free Pension Funds

              Indifferent from dividend and capital gain
VIII.   Stock Dividends

        A. Issue Stock Dividend Are Not Taxable But Have Transaction Costs

        B. Stock Dividend Have to Be Prorated

           1. Every shareholder must have the same percentage of shares increase

           2. Every shareholder must be paid in stock dividend instead of cash dividend



 IX.    Stock Buybacks

        A. The Effect of Stock Buyback

           1. Firm’s cash is reduced

           2. Fewer dividends needed to pay (Example 10.8)

           3. Better earnings per share

           4. No tax consequences for the firm; but shareholders will pay tax on the gain

               and tax deduction on the loss (Example 10.9)

        A. Management Buyout (MBO)

           1. Publicly traded share are purchased, the firm became privately held

           2. No tax consequences on the buyer but have tax consequences for the seller

           3. No public information is available for privately owned companies



  X.    Using Employee Stock Ownership Plans (ESOP)

        A. Employee Stock Ownership Plans Has the Following Advantage

           1. Dividends paid to the employees via ESOP are deductible as compensation

               expense

           2. Interests on the borrowing to fund ESOP are tax deductible
         3. Tax saving from deductible dividend payment (Example 10.10)

      B. There Are Associated Costs

         1. Cash needed to buy shares back from the open market

         2. Initial and annual legal and accounting fees to administer ESOP



XI.   Receipt of Dividends from Subsidiaries

      A. Dividends Paid to Overseas Subsidiaries

         1. Payment of a dividend instantly triggers income that previously been

             deferred

         2. Income can be tax deferred indefinitely if never paying dividend until

             liquidation

         3. Income taxes on dividends received from foreign subsidiaries can be

             reduced by a foreign tax credit (Example 10.11)

      B. Dividends Paid to United States Subsidiaries

         1. 30% taxable to parent, if under 20% ownership

         2. 20% taxable to parent, if 20-79% ownership

         3. Nontaxable to parent, if 80% or more ownership

         4. NOL carry-forward of parent or low retained earnings of the subsidiary

             a. Subsidiary has low retained earnings (Example 10.12)

             b. Parent has NOL (Example 10.13)

             c.   80% owned subsidiary, no tax event

         5. Trade off between tax saving and financial performance
                a. Subsidiary’s cash flow need and dividend payment should be weighted

                    (Example 10.14)

                b. Dividend-paying and financial performance, value-adding should be

                    weighted in decision making (Example 10.15)



XII.    Financing Ongoing Operations from a SAVANT Perspective



XIII.   Technical Insert

        A. Stock Dividend (Stock Split) – Tax Free Unless

            1. It is non-pro-rate

            2. A stock dividend is paid to any preferred stockholders

            3. Convertible stock is given

            4. Preferred stock dividends are given to common shareholders

            5. There is any distribution of convertible preferred stock

        B. Buybacks or Redemptions

            Firm buyback shares, the sellers are treated as receiving ordinary dividend

            income, unless

            1. It is substantially disproportionate

            2. The shareholder completely terminates his interest

            3. Reduction of shareholder’s interest and it is not essentially equivalent to a

                dividend

            4. It is a redemption in partial liquidation of a corporate shareholder

            5. The shareholder’s estate redeems share to pay the decedent’s death taxes