ENTREPRENEURIAL FINANCEFIFTH EDITION

Chapter 1Financial and Economic Concepts

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Chapter One Objectives

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Opportunity Costs The highest value that is surrendered

when a decision to invest funds is made.

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Choices Available for Funds

Table 1-1 Expected Financial Returns of Investment Opportunity

Investment Opportunity Expected Annual Return (%)

Purchase stock 11

Purchase home 9

Purchase bonds 6

Place money in bank savings account 2

Purchase new car -15

 

Examples of Opportunity Cost

Decide to purchase car

Opportunity cost = Stock

However, if you decided to purchase stock rather than the car

Opportunity cost = Home

Income, Expenditures, and Taxes Gross income is all of the money

received from all sources during the year.WagesTipsInterest earned on savings and bondsIncome from rental propertyProfits to entrepreneurs

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Basic Income Calculations Gross income - taxes = Disposable income

For most of us, disposable income is take-home pay.

Disposable income - Fixed expenses = Discretionary incomeFixed expenses are contractual obligations like

rent, utilities, insurance, and car payments.Discretionary income is that we can spend or

save.

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Household Name

Gross Income ($)

Income, SS, & Medicare Taxes ($)

Federal Taxes Paid

as a % of Gross

IncomeDisposable Income ($)

Fixed Expenses ($)

Discretionary Income ($)

Jones 30,000 5,228 17.43% 24,773 19,673 5,100Roberts 50,000 9,758 19.52% 40,243 32,683 7,560Smith 70,000 16,502 23.57% 53,499 40,179 13,320Brown 90,000 23,432 26.04% 66,569 41,369 25,200Meeks 110,000 29,912 27.19% 80,088 41,208 38,880Adams 130,000 36,202 27.85% 93,798 46,998 46,800Charles 150,000 42,492 28.33% 107,508 49,620 57,888

Department of the Treasury, Internal Revenue Service, Publication 15 (Rev. January 2008).

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Taxes Progressive taxes: larger percentage of

tax paid as income increases. Regressive taxes: larger percentage of

tax paid as income decreases. Proportional taxes: percentage of tax

paid remains the same at all levels of income.

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Example of Progressive Tax

Formula for tax percentage paid:

100 x dollarsin Income

dollarsin payment Tax PercentageTax

15% 100 x $20,000$3,000 percentageTax

28% 100 x $60,000$16,000 percentageTax

Income tax is progressive:

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Example of Regressive Tax

5% 100x $20,000$1,000 percentageTax

4.17% 100x $60,000$2,500 percentageTax

Sales tax is regressive:› Income = $20,000; savings = 0; sales tax = 5%› Sales tax paid = $20,000 x 0.05 = 1,000

› Income = $60,000; savings = $10,000; sales tax = 5%› Sales tax paid = $50,000 x 0.05 = $2,500

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Example of Proportional Tax

Formula for tax percentage paid:Medicare tax is 1.45%Annual income $30,000Medicare tax = $30,000 x 0.0145 = $435Annual income $500,000Medicare tax=$500,000 x 0.0145 = $7,250

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Flat Tax Proposal Gross Income ($)

Taxes Paid ($)

Percentage of Income Paid in Taxes %

30,000 - 0.0040,000 1,700 4.2550,000 3,400 6.8060,000 5,100 8.5070,000 6,800 9.7180,000 8,500 10.6390,000 10,200 11.33

100,000 11,900 11.90110,000 13,600 12.36120,000 15,300 12.75130,000 17,000 13.08140,000 18,700 13.36

Table 1-2 Flat Tax Proposal

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Factors Affecting Interest Rates The supply of money saved is primarily the

total money that is placed in demand deposit (checking) accounts, savings accounts, and money market mutual funds.

The demand for borrowed funds is all of the money that is demanded in our economy at a given price.

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Factors Affecting Interest Rates (continued) Federal Reserve Policy

The Federal Reserve is the central bank of the United States.

RiskSystematic Risk: Risk associated with economic,

political, and sociological changes that affect all participants on an equal basis.

Unsystematic Risk: Risk unique to an individual, firm, or industry.

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Table 1-4 Supply Table: Money Saved for Seven Sample Families

Annual Interest Rate (%) Jones Roberts Smith Brown Meeks Adams Charles Total

0 -$ -$ -$ -$ -$ -$ -$ -$ 2 - - - - - - - - 4 - - - 500 780 1,940 5,790 9,010 6 - - 670 1,250 1,940 2,720 7,530 14,110 8 100 200 930 1,760 2,020 3,890 12,000 20,900 10 200 500 1,500 3,000 3,500 7,000 16,000 31,700 12 250 750 2,500 5,000 6,000 10,000 20,000 44,500 14 300 1,000 3,250 9,000 12,000 15,000 25,000 65,550 16 400 1,200 4,500 12,000 18,000 23,000 31,000 90,100 18 500 1,500 6,000 15,000 25,000 28,000 38,000 114,000 20 500 1,700 8,000 18,000 30,000 32,000 40,000 130,200 22 500 1,700 8,000 18,000 30,000 33,000 41,000 132,200 24 500 1,700 8,000 18,000 30,000 33,000 41,200 132,400

Annual Savings ($000)

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Interest Rate (%)

Amount Financed ($)

Interest Paid ($)

0 180,000 01 155,454 24,5462 135,274 44,7263 118,595 61,4054 104,731 75,2695 93,141 86,8596 83,396 96,6047 75,154 104,8468 68,142 111,8589 62,141 117,85910 56,975 123,02511 52,503 127,49712 48,609 131,39113 45,200 134,80014 42,199 137,80115 39,543 140,45716 37,181 142,81917 35,071 144,92918 33,177 146,82319 31,468 148,53220 29,922 150,07821 28,516 151,48422 27,233 152,76723 26,059 153,94124 24,980 155,020

Table 1-5 Ann Smith's Demand for Money

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Type of Rate Definition Rate (%)Discount The charge on loans to depository institutions by

the New York Federal Reserve Bank 2.50Federal Funds The rate banks charge each other for overnight

loans in minimum amounts of $1 million 2.23T-bill, three months The rate on government treasury bills sold at a

discount of face value in units of $10,000 1.33Prime The interest rate that banks charge their most

creditworthy customers 5.25

Source: Federal Reserve Statistical Release H.15 - April 7, 2008

Table 1-6 Money Rates, as of April 7, 2008