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TheFinancialMarketEnvironment
Instructors Resources
Overview
Moneyandcapitalmarketsandtheirmajorcomponentsareintroducedinthischapter.Firmsneedtoraise
capitalinordertosurvive.Financialinstitutionsgivefirmsaccesstothemoneytheyneedtogrow.However,
greedcandrivefinancialmanagersandinstitutionstocommitactionsthatgetthemintotroubleandeven
forcebankruptcy.Thesebankruptciesresultinlimitedcapitalflowstofirmsandboththeyandthewhole
economycansuffer.Thefinalsectioncoversadiscussionoftheimpactoftaxationonthefirmsfinancial
activities.
Chapter2TheFinancialMarketEnvironment13
2. Financialmarketsprovideaforuminwhichsuppliersoffundsanddemandersofloansand
investmentscantransactbusinessdirectly.
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Primarymarketisthenameusedtodenotethefactthatasecurityisbeingissuedbythedemander
offundstothesupplieroffunds.AnexamplewouldbeMicrosoftCorporationsellingnewsharesof
commonstocktothepublic.
Secondarymarketreferstothetradingofsecuritiesamonginvestorssubsequenttotheprimary
marketissuance.Insecondarymarkettrading,nonewfundsarebeingraisedbythedemanderof
funds.Thesecurityistradingownershipamonginvestors.AnexamplewouldbeindividualA
buyingcommonstockofMicrosoftthroughabrokerfromindividualB.
Financialinstitutionsandfinancialmarketsarenotindependentofeachother.Itisquitecommonto
findfinancialinstitutionsactivelyparticipatinginboththemoneymarketandthecapitalmarketas
bothsuppliersanddemandersoffunds.Financialinstitutionsoftenchanneltheirinvestmentsand
obtainneededfinancingthroughthefinancialmarkets.Thisrelationshipexistssincetheseinstitutions
mustusethestructureofthefinancialmarketplacetofindasupplieroffunds.
3. Themoneymarketisafinancialrelationshipbetweenthesuppliersanddemandersofshorttermdebt
securitiesmaturinginoneyearorless,suchasU.S.Treasurybills,commercialpaper,andnegotiable
certificatesofdeposit.TheEurocurrencymarketistheinternationalequivalentoftheU.S.money
marketandisusedforshorttermbanktimedepositsdenominatedindollarsorothermajorcurrencies.
4. Thecapitalmarketisafinancialrelationshipcreatedbyanumberofinstitutionsandarrangements
thatallowsthesuppliersanddemandersoflongtermfunds(withmaturitiesgreaterthanoneyear)
tomaketransactions.Thekeysecuritiestradedinthecapitalmarketsarebondspluscommonand
preferredstock.
5. Thebrokermarketconsistsofnationalandregionalsecuritiesexchanges.Theseorganizationsprovidea
location,suchastheNewYorkStockExchange,tobringtogetherthebuyersandsellersofdebtand
equity.Theycreateacontinuousmarketforsecurities,allocatescarcecapital,determineandpublicize
securityprices,andaidinnewfinancing.
Bycontrast,dealermarketsareelectronicmarketsforthebuyersandsellersofsecuritiesnotlistedon
themajorexchanges.Inabrokermarket,physicaltradinglocationsarereplacedbysecuritydealers
whooffertobuyorsellsecuritiesatstatedbid/askprices.Dealersbuysecuritiesfromclients,sell
themtootherdealers,whointurnsellthemtotheirclients.Amajorityofsharestradedinthedealer
marketarelistedonNasdaq,theNationalAssociationofSecuritiesDealersAutomatedQuotation
System.
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6. InadditiontotheU.S.capitalmarkets,corporationscanraisedebtandequityfundsincapitalmarkets
locatedinothercountries.TheEurobondmarketistheoldestandlargestinternationaldebtmarket.
Corporateandgovernmentbondsissuedinthismarketaredenominatedindollarsorothermajor
currenciesandsoldtoinvestorsoutsidethecountryinwhosecurrencythebondsaredenominated.
Foreignbondmarketsalsoprovidecorporationswiththeopportunitytotapothercapitalsources.
Corporationsorgovernmentsissuebondsdenominatedinthelocalcurrencyandsoldonlyinthat
homemarket.Theinternationalequitymarketallowscorporationstosellblocksofstocktoinvestors
inseveralcountries,providingadiversifiedinvestorbaseandadditionalopportunitiestoraiselarger
amountsofcapital.
7. Anefficientmarketwillallocatefundstotheirmostproductiveusesduetocompetitionamong
wealthmaximizinginvestors.Pricesareassumedtobeafunctionofinformationaboutthefirmand
economy.Onlynew,unexpectedinformationwillcauseinvestorstobuyorsellsecurities.Investors
determinethepriceofassetsthroughtheirparticipationinthefinancialmarkets.Changesinsupply
anddemandcontinuallyimpactpricesinanefficientmarket.
Analternativeviewofmarketpricingisputforthbyadvocatesofbehavioralfinance.Thisexplanation
ofmarketpricescombinesfinanceandpsychology.Thoughpricesmaydeviatefromtruevaluefor
psychologicalandotherreasons,fewinvestorshavebeenabletoearnariskadjusted,positiverate
ofreturn.
8. Securitizationistheprocessofpoolingmortgagesandthensellingclaimsagainstthatpoolinthe
secondarymarket.Investorsbuyingthesesecuritiesextendaloantothehomeowner.
9. Mortgagebackedsecuritiesrepresentclaimsonthecashflowsgeneratedbyapoolofmortgages.As
thehomeownerspayofftheirmortgages,themoneyservesasincometotheinvestors.Theprimary
riskassociatedwithmortgagebackedsecuritiesisthathomeownersmaynotrepaytheirloans.
10. Whenahomeownerborrowsmoneytobuyahome,heborrowsafixedamountofmoney.Ashousing
pricesrise,thegapbetweenwhatheowesandwhatthehouseisworthwidens.Lenderswillallow
borrowerswhohavedifficultymakingmortgagepaymentstapthisbuiltupequity.Therefore,
mortgagedefaultratesarerelativelylow.
11. Ashomepricesdecline,thevalueofhomesmaybelessthantheamountowedtothebank.Hence
manyborrowerswillsimplywalkawayfromtheirhomesandletlendersrepossessthem.Therewill
beanaddedsupplyofhousing.Ifmultiplehomesintheareaarefacingforeclosure,thevalueof
remaininghomeswilldrop.Atthesametime,borrowershavingtroublemakingmortgagepayments
willnotbeabletotapintoanybuiltupequity.Thesehomeswillalsoberepossessed,andthenumber
ofhomesforsaleinanareawillrise.Excesshomeavailabilitywillmaketheremaininghomesless
valuable,increasingthenumberofhomeownerswithhousesworthlessthantheamountowedtothe
bank.Itisaviciouscycle.
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12. Asmortgagebackedsecuritydelinquencyratesrose,thevalueofstillsolventmortgageback
securitiesfell.Thisfallledtothequestionsaboutthesolvencyofinvestors,includingfinancial
institutions.Financialinstitutionscutbackontheamountoflending,requiringhigherstandardsfor
thoseborrowingmoney.Unabletoobtainmoneyeasilyinthemoneymarket,firmsbegantohoard
cashandcutbackexpenditures.Thisdeclinehurtsuppliersandcurtailedemploymentatcompanies.
Throughouttheeconomyrevenuesfallasfinancialinstitutionscutbackonlending.
13. Duetotheirenormousimpact,governmentstypicallyregulatefinancialinstitutionsmorethanmost
economicsectors.Bankingsectortroublesandotherfactorscontributedtotheworsteconomic
contractioninU.S.historyduringtheGreatDepression.Consequently,itisnotsurprisingthatan
aboveaverageamountoflegislationwasenactedinthe1930s.
14. TheSecuritiesActof1933wasdesignedtoregulateactivityintheprimarymarket,ensuringthat
sellersofnewsecuritiesprovidedextensivedisclosure.TheSecuritiesExchangeActof1934
regulatesthetradingofsecuritiesinsecondarymarkets.Thelatterlegislationalsocreatedthe
SecuritiesExchangeCommissiontoenforcefederalsecuritieslaws.
15. Theordinaryincomeofacorporationisincomeearnedthroughthesaleofafirmsgoodsorservices.
Taxesoncorporateordinaryincomehavetwocomponents:afixedamountonthebasefigureforits
incomebracketlevel,plusaprogressivepercentage,rangingfrom15%to39%,appliedtotheexcess
overthebasebracketfigure.Acapitalgainoccurswhenacapitalassetissoldformorethanitsinitial
purchaseprice.Capitalgainsareaddedtoordinaryincomeandtaxedattheregularcorporaterates.
Theaveragetaxrateiscalculatedbydividingtaxespaidbytaxableincome.Forfirmswithtaxable
incomeof$10millionorless,itrangesfrom15%to34%.Forfirmswithtaxableincomeinexcessof
$10million,itrangesbetween34%and35%.Themarginaltaxrateistherateatwhichadditional
incomeistaxed.
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16. Dividendsreceivedfromanothercorporation,inwhichtheshareholdingfirmspositionislessthan
onefifthofoutstandingshares,issubjecttoa70%exclusionfortaxpurposes.Thetaxrateisonly
30%ofwhatitwouldbeonfullytaxableincome.
17. Thetaxdeductibilityofcorporateexpensesreducestheiractualaftertaxcost.Corporateinterestisa
taxdeductibleexpense,whiledividendsarenot.
Suppliersanddemandersoffunds
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Answer: Individualsasawholespendlessthantheyconsume.Theexcessisinvested,makingit
availableforbusinesses.Ifindividualsconsumemore,fewerdollarswillbeavailablefor
investment.Thiswouldreducetheamountofmoneyavailablefornewprojectsanddriveup
therequiredreturn(i.e.,requiredreturnofinvestorsbuybonds).Overtime,employment,
salaries,andgrossdomesticproductwoulddecline.
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E22
Raisingfunds
Answer: Financialinstitutions,suchasinvestmentbanks,provideexpertiseintheacquisitionoffunds.
Investmentbankinginstitutionsareabletousetheexpertisedevelopedthroughtheacquisition
offundsformanyfirmstoreducetheeffortandcostofacquiringfundsforanysinglebusiness.
TheinvestmentbankinginstitutionwillallowtheGagaEnterprisesCFOtoraisemoremoney
atalowercostperdollarraised.
E23
Moneymarketvs.capitalmarket
Answer: Moneymarketsareshorttermmarkets,sofirmsusingthesewouldbeinneedoffundsforless
thanayear.Perhapsthebusinessneedstoincreaseinventoryforaseason,suchasRVdealerships
buildinginventorypriortothespring/summersalesperiod.Immediatelyafteralargesale,a
businessmayneedtofinancethepresenceofaccountsreceivableontheirbalancesheet.Capital
markets,bycontrast,aretypicallyusedforfixedassets,whichacompanywilluseoverseveral
years.
E24
Mortgagebackedsecurities
Answer: Questionsyouwouldaskinclude:
a. Realestatelocation(afterall,thethreemostimportantdeterminantsofrealestatepriceare
location,location,location)
b. Percentageofpropertiesintheregionthatareunderwater(homeownersowemorethan
theyborrowed)orinforeclosure
c. Typeofrealestate(commercialpropertiesofferlessliquidityifthemarketturnssour,
becauseemptyhomescanberentedforrevenue)
d. Precedenceinbankruptcy(wouldotherlendershaveaseniorclaimtopropertiesin
bankruptcy?)
e. Qualityofrealestate(isitingoodcondition,orwouldthereneedtoberepairspriorto
sale?)
f.
Creditworthinessofborrowers(howlikelyisitthatborrowerswilllosetheirjobandbe
unabletomakepaymentsonatimelybasis?)
g. Whatpercentageofborrowersarebehindontheirmortgagepayments
h. Willborrowerssoonbeexperiencinganinterestrateincreasebecausetheytookouta
mortgagewithalowinitialratethatwasadjustableafteraperiodoftime
E25.
Dividendsreceivedexclusion
Answer: While100%ofcorporateinterestincomeistaxedatordinarytaxrates,only30%ofcorporate
dividendincomeistreatedastaxableincome.Thiswouldbetheequivalentofrecognizing
only1.5%[5%(10.7)]ofthe5%annualdividendfortaxpurposes.Basedsolelyonthetax
treatmentofcorporatedividendincomevs.interestincome,Pruro,Inc.wouldhavegreater
aftertaxincomeifitchoosestheRestonstockpaying5%dividendsoverthepromissorynote
paying5%interest.
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Solutions to Problems
P21.
Corporatetaxes
LG6;Basic
a. Firmstaxliabilityon$92,500(fromTable2.1):
Totaltaxesdue$13,750[0.34($92,500$75,000)]
$13,750(0.34$17,500)
$13,750$5,950
$19,700
b. Aftertaxearnings:$92,500$19,700$72,800
c.
Averagetaxrate:$19,700$92,50021.3%
d. Marginaltaxrate:34%
P22.
Averagecorporatetaxrates
LG6;Basic
a.
TaxcalculationsusingTable2.1:
$10,000:
Taxliability:
$10,0000.15$1,500
Aftertaxearnings: $10,000$1,500$8,500
$80,000:
Averagetaxrate:
$1,500$10,00015%
Taxliability:
$13,750[0.34(80,000$75,000)]
$13,750(0.34$5,000)
$13,750$1,700
$15,450Totaltax
Aftertaxearnings: $80,000$15,450$64,550
$300,000:
Averagetaxrate:
$15,450$80,00019.3%
Taxliability:
$22,250+[0.39($300,000$100,000)]
$22,250(0.39$200,000)
$22,250$78,000
$100,250Totaltax
Aftertaxearnings: $300,000$100,250$199,750
Averagetaxrate:
$100,250$300,00033.4%
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$500,000:
Taxliability:
$113,900[0.34($500,000$335,000)]
$113,900(0.34$165,000)
$113,900$56,100
$170,000Totaltax
Aftertaxearnings: $500,000$170,000$330,000
$1,500,000:
Averagetaxrate:
$170,000$500,00034%
Taxliability:
$113,900[0.34($1,500,000$335,000)]
$113,900(0.34$1,165,000)
$113,900$396,100
$510,000Totaltax
Aftertaxearnings: $1,500,000$510,000$990,000
Averagetaxrate:
$10,000,000: Taxliability:
$510,000$1,500,00034%
$113,900+[0.34($10,000,000$335,000)]
$113,900(0.34$9,665,000)
$113,900$3,286,100
$3,400,000Totaltax
Aftertaxearnings: $10,000,000$3,400,000$6,600,000
Averagetaxrate:
$20,000,000: Taxliability:
$3,400,000$10,000,00034%
$6,416,667[0.35($20,000,000$18,333,333)]
$6,416,667(0.35$1,666,667)
$6,416,667583,333
$7,000,000Totaltax
Aftertaxearnings: $20,000,000$7,000,000$13,000,000
Averagetaxrate:
$7,000,000$20,000,00035%
b.
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Asincomeincreases,theratereaches35%.
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P23.
Marginalcorporatetaxrates
LG6;Basic
a.
TaxCalculation
Pretax
Income
BaseTax
$15,000
60,000
90,000
200,000
400,000
1,000,000
20,000,000
$0
7,500
13,750
22,250
113,900
113,900
6,416,667
%
(0.15
(0.25
(0.34
(0.39
(0.34
(0.34
(0.35
Amount
overBase
15,000)
10,000)
15,000)
100,000)
65,000)
665,000)
1,666,667)
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Total
Tax
Marginal
Rate
$2,250
10,000
18,850
61,250
136,000
340,000
7,00,0000
15.0%
25.0%
34.0%
39.0%
34.0%
34.0%
35.0%
35Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
b.
Asincomeincreasesto$335,000,themarginaltaxrateapproachesandpeaksat39%.For
incomeinexcessof$335,000,themarginaltaxratedeclinesto34%,andafter$10million
themarginalrateincreasesslightlyto35%.
P24.
Interestvs.dividendincome
LG6;Intermediate
a.
Taxonoperatingearnings:$490,0000.40taxrate$196,000
b.andc.
Beforetaxamount
Less:Applicableexclusion
Taxableamount
Tax(40%)
Aftertaxamount
(b)
InterestIncome
(c)
DividendIncome
$20,000
0
20,000
8,000
12,000
$20,000
14,000
6,000
2,400
17,600
(0.70$20,000)
d. Theaftertaxamountofdividendsreceived,$17,600,exceedstheaftertaxamountofinterest,
$12,000,duetothe70%corporatedividendexclusion.Thisincreasestheattractivenessof
stockinvestmentsbyonecorporationinanotherrelativetobondinvestments.
e.
Totaltaxliability:
Taxesonoperatingearnings(froma.)
$196,000
Taxesoninterestincome(fromb.)
8,000
Taxesondividendincome(fromc.)
2,400
Totaltaxliability
$206,400
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P25.
Interestvs.dividendexpense
LG6;Intermediate
a. EBIT
$40,000
Less:Interestexpense
10,000
Earningsbeforetaxes
$30,000
Less:Taxes(40%)
12,000
Earningsaftertaxes*
$18,000
Thisisalsoearningsavailabletocommonstockholders.
b. EBIT
$40,000
Less:Taxes(40%)
16,000
Earningsaftertaxes
$24,000
Less:Preferreddividends
10,000
Earningsavailablefor
commonstockholders
$14,000
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P26.
Capitalgainstaxes
LG6;Basic
a.
Capitalgain:
AssetX$2,250$2,000$250
AssetY$35,000$30,000$5,000
b. Taxonsaleofasset:
AssetX$2500.40$100
AssetY$5,0000.40$2,000
P27.
Capitalgainstaxes
LG6;Basic
a.andb.
Asset
A
B
C
D
E
SalePrice
(1)
$3,400
12,000
80,000
45,000
18,000
PurchasePrice
(2)
$3,000
12,000
62,000
41,000
16,500
CapitalGain
(1)(2)
(3)
$400
0
18,000
4,000
1,500
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Tax
(3)0.40
(4)
$160
0
7,200
1,600
600
41Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
P28.
Ethicsproblem
LG5;Intermediate
Theprimaryethicalissueiswhethertheinsiderisbasinghisbuyorsaleofcompanyshareson
internalinformation.Ifheisbasinghisdecisionsoninformationnotavailabletothegeneral
public,hewouldbemakingdecisionsinanunethicalmanner.Theinsidermayforinstancebe
awareofthelikelihoodofafavorableacquisition,andunethicallybuycompanysharesonthat
knowledge.Ontheotherhand,insidersalesbaseduponsoontobereleasedinformationabout
thelossofanimportantcontracttoacompetitor,wouldalsobeunethical.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Spreadsheet Exercise
TheanswertoChapter2sMonsantospreadsheetproblemislocatedontheInstructorsResourceCenter
atwww.pearsonhighered.com/ircundertheInstructorsManual.
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Group Exercise
ThereisnogroupexerciseforChapter2.
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