7491 Gitman Ch02 pp030-054 -...

Why This Chapter Matters to You

In your professional lifeACCOUNTING You need to understand how business income is taxedand the difference between average and marginal tax rates.

INFORMATION SYSTEMS You need to understand how informationflows between the firm and financial markets.

MANAGEMENT You need to understand why healthy financial institu-tions are an integral part of a healthy economy and how a crisis in thefinancial sector can spread and affect almost any type of business.

MARKETING You need to understand why it is important for firms tocommunicate about their operating results with external investors andhow regulations constrain the types of communication that occur.

OPERATIONS You need to understand why external financing is, formost firms, an essential aspect of ongoing operations.

Making financial transactions willbe a regular occurrence throughout

your entire life. These transactions may be as simple as depositing yourpaycheck in a bank or as complex as deciding how to allocate themoney you save for retirement among different investment options.Many of these transactions have important tax consequences, whichvary over time and from one type of transaction to another. The contentin this chapter will help you make better decisions when you engage inany of these transactions.

In your personal life

Learning GoalsUnderstand the role that financialinstitutions play in managerialfinance.

Contrast the functions of financialinstitutions and financial markets.

Describe the differences betweenthe capital markets and themoney markets.

Explain the root causes of the2008 financial crisis andrecession.

Understand the major regulationsand regulatory bodies that affectfinancial institutions and markets.

Discuss business taxes and theirimportance in financial decisions.

LG 6

LG 5

LG 4

LG 3

LG 2

LG 1

2 The Financial MarketEnvironment

30

7491_Gitman_Ch02_pp030-054.qxd 12/2/10 11:45 AM Page 30

31

Cut to the Chase

Since the recession of the early 1990s, business

had been booming for JPMorgan Chase, one of

the leading investment banking firms on Wall Street.

After hitting a low of roughly $2 per share in October

1990, Chase stock went on a tear, rising at a rate of

about 21 percent per year and hitting the $50 range

by April 2007. The bank’s investors enjoyed

increasing dividend payments along with the rising

stock price. JPMorgan Chase increased its dividend payout from $0.0833 per share in

December 1990 to $0.38 per share in July 2007, an increase of more than 350 percent.

Trouble was brewing, however. In the summer of 2007, data began to emerge that prices

of single-family homes were falling in many U.S. cities and homeowners were starting to default

on their mortgages. Rumors swirled that JPMorgan and other banks held large investments in

securities tied to residential mortgages. On September 15, 2008, the venerable investment

banking firm, Lehman Brothers, filed for bankruptcy, and JPMorgan shares fell 10 percent in a

single day. Bad news about the economy and the financial sector continued through the fall,

and Chase’s stock hit a low point on November 21 near $20, losing more than half its value in

roughly 18 months.

All of this prompted JPMorgan management to make two difficult decisions. The first was

to accept a $25 billion “investment” (some referred to it as a bailout) from the U.S. Treasury on

October 28, 2008. The second was to cut its quarterly dividend by almost 87 percent, from

$0.38 to $0.05 per share. These decisions, combined with a slowly improving economy,

helped JPMorgan survive the 2008 financial crisis and the subsequent recession. By the summer

of 2009, JPMorgan Chase repaid the $25 billion (with interest) that it had received from the

government, and the bank’s stock had recovered most of the value that it had lost.

JPMorgan Chase & Co.


32 PART 1 Introduction to Managerial Finance

2.1 Financial Institutions and Markets

Most successful firms have ongoing needs for funds. They can obtain funds fromexternal sources in three ways. The first source is through a financial institutionthat accepts savings and transfers them to those that need funds. A second sourceis through financial markets, organized forums in which the suppliers anddemanders of various types of funds can make transactions. A third source isthrough private placement. Because of the unstructured nature of private place-ments, here we focus primarily on the role of financial institutions and financialmarkets in facilitating business financing.

FINANCIAL INSTITUTIONS

Financial institutions serve as intermediaries by channeling the savings of individ-uals, businesses, and governments into loans or investments. Many financialinstitutions directly or indirectly pay savers interest on deposited funds; othersprovide services for a fee (for example, checking accounts for which customerspay service charges). Some financial institutions accept customers’ savingsdeposits and lend this money to other customers or to firms; others invest customers’ savings in earning assets such as real estate or stocks and bonds; andsome do both. Financial institutions are required by the government to operatewithin established regulatory guidelines.

Key Customers of Financial Institutions

For financial institutions, the key suppliers of funds and the key demanders offunds are individuals, businesses, and governments. The savings that individualconsumers place in financial institutions provide these institutions with a largeportion of their funds. Individuals not only supply funds to financial institutionsbut also demand funds from them in the form of loans. However, individuals as agroup are the net suppliers for financial institutions: They save more money thanthey borrow.

Business firms also deposit some of their funds in financial institutions, pri-marily in checking accounts with various commercial banks. Like individuals,firms borrow funds from these institutions, but firms are net demanders of funds:They borrow more money than they save.

Governments maintain deposits of temporarily idle funds, certain tax pay-ments, and Social Security payments in commercial banks. They do not borrowfunds directly from financial institutions, although by selling their debt securitiesto various institutions, governments indirectly borrow from them. The govern-ment, like business firms, is typically a net demander of funds: It typically bor-rows more than it saves. We’ve all heard about the federal budget deficit.

Major Financial Institutions

The major financial institutions in the U.S. economy are commercial banks, sav-ings and loans, credit unions, savings banks, insurance companies, mutual funds,and pension funds. These institutions attract funds from individuals, businesses,and governments, combine them, and make loans available to individuals andbusinesses.

LG 3LG 2LG 1

financial institutionAn intermediary that channelsthe savings of individuals,businesses, and governmentsinto loans or investments.

7491_Gitman_Ch02_pp030-054.qxd 12/2/10 11:45 AM 2

COMMERCIAL BANKS, INVESTMENT BANKS, AND THESHADOW BANKING SYSTEM

Commercial banks are among the most important financial institutions in theeconomy because they provide savers with a secure place to invest funds and theyoffer both individuals and companies loans to finance investments, such as thepurchase of a new home or the expansion of a business. Investment banks areinstitutions that (1) assist companies in raising capital, (2) advise firms on majortransactions such as mergers or financial restructurings, and (3) engage in tradingand market making activities.

The traditional business model of a commercial bank—taking in and payinginterest on deposits and investing or lending those funds back out at higherinterest rates—works to the extent that depositors believe that their investmentsare secure. Since the 1930s, the U.S. government has given some assurance todepositors that their money is safe by providing deposit insurance (currently upto $250,000 per depositor). Deposit insurance was put in place in response to thebanking runs or panics that were part of the Great Depression. The same act ofCongress that introduced deposit insurance, the Glass-Steagall Act, also created aseparation between commercial banks and investment banks, meaning that aninstitution engaged in taking in deposits could not also engage in the somewhatriskier activities of securities underwriting and trading.

Commercial and investment banks remained essentially separate for more than 50 years, but in the late 1990s Glass-Steagall was repealed. Companies that had for-merly engaged only in the traditional activities of a commercial bank began com-peting with investment banks for underwriting and other services. In addition, the1990s witnessed tremendous growth in what has come to be known as the shadowbanking system. The shadow banking system describes a group of institutions thatengage in lending activities, much like traditional banks, but these institutions donot accept deposits and are therefore not subject to the same regulations as tradi-tional banks.1 For example, an institution such as a pension fund might have excesscash to invest, and a large corporation might need short-term financing to cover sea-sonal cash flow needs. A business like Lehman Brothers acted as an intermediarybetween these two parties, helping to facilitate a loan, and thereby became part ofthe shadow banking system. In March 2010, Treasury Secretary Timothy Geithnernoted that at its peak the shadow banking system financed roughly $8 trillion inassets and was roughly as large as the traditional banking system.

CHAPTER 2 The Financial Market Environment 33

commercial banksInstitutions that provide saverswith a secure place to investtheir funds and that offer loansto individual and businessborrowers.

investment banksInstitutions that assistcompanies in raising capital,advise firms on majortransactions such as mergers orfinancial restructurings, andengage in trading and marketmaking activities.

Glass-Steagall ActAn act of Congress in 1933that created the federal depositinsurance program andseparated the activities ofcommercial and investmentbanks.

1. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in response to the finan-cial crisis and recession of 2008–2009. This legislation will likely have a dramatic impact on the regulation of bothtraditional and shadow banking institutions, but it is too early to tell exactly what the new law’s effects will be. Inthe wake of the law’s passage, many commentators suggested that the law did not exercise enough oversight of theshadow banking system to prevent a financial meltdown similar to the one that motivated the law’s enactment.

shadow banking systemA group of institutions thatengage in lending activities,much like traditional banks, butdo not accept deposits andtherefore are not subject to thesame regulations as traditionalbanks.

Matter of fact

The U.S. banking industry has been going through a long period of consolidation. Accordingto the FDIC, the number of commercial banks in the United States declined from 11,463 in

1992 to 8,012 at the end of 2009, a decline of 30 percent. The decline is concentrated amongsmall community banks, which larger institutions have been acquiring at a rapid pace.

Consolidation in the U.S. Banking Industry


FINANCIAL MARKETS

Financial markets are forums in which suppliers of funds and demanders of fundscan transact business directly. Whereas the loans made by financial institutionsare granted without the direct knowledge of the suppliers of funds (savers), sup-pliers in the financial markets know where their funds are being lent or invested.The two key financial markets are the money market and the capital market.Transactions in short-term debt instruments, or marketable securities, take placein the money market. Long-term securities—bonds and stocks—are traded in thecapital market.

To raise money, firms can use either private placements or public offerings. Aprivate placement involves the sale of a new security directly to an investor orgroup of investors, such as an insurance company or pension fund. Most firms,however, raise money through a public offering of securities, which is the sale ofeither bonds or stocks to the general public.

When a company or government entity sells stocks or bonds to investors andreceives cash in return, it is said to have sold securities in the primary market. Afterthe primary market transaction occurs, any further trading in the security does notinvolve the issuer directly, and the issuer receives no additional money from thesesubsequent transactions. Once the securities begin to trade between investors, theybecome part of the secondary market. On large stock exchanges, billions of sharesmay trade between buyers and sellers on a single day, and these are all secondarymarket transactions. Money flows from the investors buying stocks to the investorsselling them, and the company whose stock is being traded is largely unaffected bythe transactions. The primary market is the one in which “new” securities are sold.The secondary market can be viewed as a “preowned” securities market.

THE RELATIONSHIP BETWEEN INSTITUTIONS AND MARKETS

Financial institutions actively participate in the financial markets as both sup-pliers and demanders of funds. Figure 2.1 depicts the general flow of fundsthrough and between financial institutions and financial markets as well as the


financial marketsForums in which suppliers offunds and demanders of fundscan transact business directly.

private placementThe sale of a new securitydirectly to an investor or groupof investors.

public offeringThe sale of either bonds orstocks to the general public.

primary marketFinancial market in whichsecurities are initially issued;the only market in which theissuer is directly involved in thetransaction.

secondary marketFinancial market in whichpreowned securities (those thatare not new issues) are traded.

PrivatePlacement

Suppliersof Funds

Demandersof Funds

FinancialInstitutions

FinancialMarkets

Funds

Deposits/Shares

Funds

Loans

Securities

Securities

Secu

ritie

s

Securities

Funds Funds

Funds

Fund

s

FIGURE 2 .1

Flow of FundsFlow of funds for financialinstitutions and markets


mechanics of private placement transactions. Domestic or foreign individuals, busi-nesses, and governments may supply and demand funds. We next briefly discuss themoney market, including its international equivalent—the Eurocurrency market.We then end this section with a discussion of the capital market, which is of keyimportance to the firm.

THE MONEY MARKET

The money market is created by a financial relationship between suppliers anddemanders of short-term funds (funds with maturities of one year or less). Themoney market exists because some individuals, businesses, governments, andfinancial institutions have temporarily idle funds that they wish to invest in a rel-atively safe, interest-bearing asset. At the same time, other individuals, busi-nesses, governments, and financial institutions find themselves in need ofseasonal or temporary financing. The money market brings together these sup-pliers and demanders of short-term funds.

Most money market transactions are made in marketable securities—short-term debt instruments, such as U.S. Treasury bills, commercial paper, andnegotiable certificates of deposit issued by government, business, and financialinstitutions, respectively. Investors generally consider marketable securities to beamong the least risky investments available. Marketable securities are describedin Chapter 15.

The international equivalent of the domestic money market is called theEurocurrency market. This is a market for short-term bank deposits denominatedin U.S. dollars or other major currencies. Eurocurrency deposits arise when a cor-poration or individual makes a bank deposit in a currency other than the localcurrency of the country where the bank is located. If, for example, a multina-tional corporation were to deposit U.S. dollars in a London bank, this wouldcreate a Eurodollar deposit (a dollar deposit at a bank in Europe). Nearly allEurodollar deposits are time deposits. This means that the bank would promiseto repay the deposit, with interest, at a fixed date in the future—say, in 6 months.During the interim, the bank is free to lend this dollar deposit to creditworthycorporate or government borrowers. If the bank cannot find a borrower on itsown, it may lend the deposit to another international bank.

THE CAPITAL MARKET

The capital market is a market that enables suppliers and demanders of long-termfunds to make transactions. Included are securities issues of business and govern-ment. The backbone of the capital market is formed by the broker and dealermarkets that provide a forum for bond and stock transactions. International cap-ital markets also exist.

Key Securities Traded: Bonds and Stocks

The key capital market securities are bonds (long-term debt) and both commonstock and preferred stock (equity, or ownership).

Bonds are long-term debt instruments used by business and government toraise large sums of money, generally from a diverse group of lenders. Corporatebonds typically pay interest semiannually (every 6 months) at a stated couponinterest rate. They have an initial maturity of from 10 to 30 years, and a par, or


money marketA financial relationship created between suppliers anddemanders of short-term funds.

marketable securitiesShort-term debt instruments,such as U.S. Treasury bills,commercial paper, andnegotiable certificates ofdeposit issued by government,business, and financialinstitutions, respectively.

Eurocurrency marketInternational equivalent of thedomestic money market.

capital marketA market that enables suppliersand demanders of long-termfunds to make transactions.

bondLong-term debt instrument usedby business and government toraise large sums of money,generally from a diverse groupof lenders.


face, value of $l,000 that must be repaid at maturity. Bonds are described indetail in Chapter 7.

Lakeview Industries, a major microprocessor manufacturer, has issued a 9%coupon interest rate, 20-year bond with a $1,000 par value that pays interestsemiannually. Investors who buy this bond receive the contractual right to $90annual interest (9% coupon interest rate par value) distributed as $45at the end of each 6 months for 20 years, plus the $1,000 par valueat the end of year 20.

As noted earlier, shares of common stock are units of ownership, or equity, ina corporation. Common stockholders earn a return by receiving dividends—periodic distributions of cash—or by realizing increases in share price. Preferredstock is a special form of ownership that has features of both a bond andcommon stock. Preferred stockholders are promised a fixed periodic dividendthat must be paid prior to payment of any dividends to common stockholders. Inother words, preferred stock has “preference” over common stock. Preferredstock and common stock are described in detail in Chapter 8. See the Focus onPractice box for the story of one legendary stock price and the equally legendaryman who brought it about.

Broker Markets and Dealer Markets

By far the vast majority of trades made by individual investors take place in thesecondary market. When you look at the secondary market on the basis of howsecurities are traded, you will find you can essentially divide the market into twosegments: broker markets and dealer markets.

The key difference between broker and dealer markets is a technical pointdealing with the way trades are executed. That is, when a trade occurs in a brokermarket, the two sides to the transaction, the buyer and the seller, are broughttogether and the trade takes place at that point: Party A sells his or her securitiesdirectly to the buyer, Party B. In a sense, with the help of a broker, the securitieseffectively change hands on the floor of the exchange. The broker market consistsof national and regional securities exchanges, which are organizations that pro-vide a marketplace in which firms can raise funds through the sale of new securi-ties and purchasers can resell securities.

In contrast, when trades are made in a dealer market, the buyer and the sellerare never brought together directly. Instead, market makers execute the buy/sellorders. Market makers are securities dealers who “make markets” by offering tobuy or sell certain securities at stated prices. Essentially, two separate trades aremade: Party A sells his or her securities (in, say, Dell) to a dealer, and Party B buyshis or her securities (in Dell) from another, or possibly even the same, dealer.Thus, there is always a dealer (market maker) on one side of a dealer–markettransaction. The dealer market is made up of both the Nasdaq market, an all-electronic trading platform used to execute securities trades, and the over-the-counter (OTC) market, where smaller, unlisted securities are traded.

Broker Markets If you are like most people, when you think of the “stockmarket” the first name to come to mind is the New York Stock Exchange, knowncurrently as the NYSE Euronext after a series of mergers that expanded the

(1/2 * $90)* $1,000

Example 2.1 3


preferred stockA special form of ownershiphaving a fixed periodicdividend that must be paidprior to payment of anydividends to commonstockholders.

broker marketThe securities exchanges onwhich the two sides of atransaction, the buyer andseller, are brought together totrade securities.

securities exchangesOrganizations that provide themarketplace in which firms canraise funds through the sale ofnew securities and purchaserscan resell securities.

dealer marketThe market in which the buyerand seller are not broughttogether directly but insteadhave their orders executed bysecurities dealers that “makemarkets” in the given security.

market makersSecurities dealers who “makemarkets” by offering to buy orsell certain securities at statedprices.

Nasdaq marketAn all-electronic tradingplatform used to executesecurities trades.

over-the-counter (OTC)marketMarket where smaller, unlistedsecurities are traded.



focus on PRACTICE

Berkshire Hathaway—Can Buffett Be Replaced?In early 1980,investors could buy

one share of Berkshire Hathaway ClassA common stock (stock symbol: BRKA)for $285. That may have seemedexpensive at the time, but by September2010 the price of just one share hadclimbed to $125,000. The wizardbehind such phenomenal growth inshareholder value is the chairman ofBerkshire Hathaway, Warren Buffett,nicknamed the Oracle of Omaha.

With his partner, Vice-ChairmanCharlie Munger, Buffett runs a largeconglomerate of dozens of subsidiarieswith 222,000 employees and morethan $112 billion in annual revenues.He makes it look easy. In his words,“I’ve taken the easy route, just sittingback and working through great man-agers who run their own shows. Myonly tasks are to cheer them on, sculptand harden our corporate culture, andmake major capital-allocation deci-sions. Our managers have returned thistrust by working hard and effectively.”a

in practice Buffett’s style of corporate leader-ship seems rather laid back, but behindthat “aw-shucks” manner is one of thebest analytical minds in business. Hebelieves in aligning managerial incen-tives with performance. Berkshireemploys many different incentivearrangements, with their terms depend-ing on such elements as the economicpotential or capital intensity of a CEO’sbusiness. Whatever the compensationarrangement, Buffett tries to keep it bothsimple and fair. Buffett himself receivesan annual salary of $100,000—notmuch in this age of supersized CEOcompensation packages. Listed formany years among the world’s wealthi-est people, Buffett has donated most ofhis Berkshire stock to the Bill andMelinda Gates Foundation.

Berkshire’s annual report is a must-read for many investors due to the pop-ularity of Buffett’s annual letter toshareholders with his homespun take onsuch topics as investing, corporate gov-ernance, and corporate leadership.

Shareholder meetings in Omaha,Nebraska, have turned into cultlikegatherings, with thousands traveling tolisten to Buffett answer questions fromshareholders. One question that hasbeen firmly answered is the question of Mr. Buffett’s ability to create share-holder value.

The next question that needs to be answered is whether BerkshireHathaway can successfully replaceBuffett (age 80) and Munger (age 86).In October 2010, Berkshire hiredhedge fund manager Todd Combs tohandle a significant portion of the firm’sinvestments. Berkshire shareholdershope that Buffett’s special wisdomapplies as well to identifying new man-agerial talent as it does to makingstrategic investment decisions.

3 The share price of BRKA hasnever been split. Why might thecompany refuse to split its sharesto make them more affordable toaverage investors?

exchange’s global reach. In point of fact, the NYSE Euronext is the dominantbroker market. The American Stock Exchange (AMEX), which is anothernational exchange, and several so-called regional exchanges are also broker mar-kets. These exchanges account for about 60 percent of the total dollar volume ofall shares traded in the U.S. stock market. In broker markets all the trading takesplace on centralized trading floors.

Most exchanges are modeled after the New York Stock Exchange. For afirm’s securities to be listed for trading on a stock exchange, a firm must file anapplication for listing and meet a number of requirements. For example, to be eli-gible for listing on the NYSE, a firm must have at least 400 stockholders owning100 or more shares; a minimum of 1.1 million shares of publicly held stock out-standing; pretax earnings of at least $10 million over the previous 3 years, with atleast $2 million in the previous 2 years; and a minimum market value of publicshares of $100 million. Clearly, only large, widely held firms are candidates forNYSE listing.

Once placed, an order to buy or sell on the NYSE can be executed in minutes,thanks to sophisticated telecommunication devices. New Internet-based bro-kerage systems enable investors to place their buy and sell orders electronically.

aBerkshire Hathaway, Inc., “Letter to Shareholders of Berkshire Hathaway, Inc.,” 2006 Annual Report, p. 4.


Information on publicly traded securities is reported in various media, both print, such as the Wall Street Journal, and electronic, such as MSN Money (www.moneycentral.msn.com).

Dealer Markets One of the key features of the dealer market is that it hasno centralized trading floors. Instead, it is made up of a large number of marketmakers who are linked together via a mass-telecommunications network.

Each market maker is actually a securities dealer who makes a market in oneor more securities by offering to buy or sell them at stated bid/ask prices. The bidprice and ask price represent, respectively, the highest price offered to purchase agiven security and the lowest price at which the security is offered for sale. Ineffect, an investor pays the ask price when buying securities and receives the bidprice when selling them.

As described earlier, the dealer market is made up of both the Nasdaqmarket and the over-the-counter (OTC) market, which together account forabout 40 percent of all shares traded in the U.S. market—with the Nasdaqaccounting for the overwhelming majority of those trades. (As an aside, theprimary market is also a dealer market because all new issues are sold to theinvesting public by securities dealers, acting on behalf of the investmentbanker.)

The largest dealer market consists of a select group of stocks that are listedand traded on the National Association of Securities Dealers AutomatedQuotation System, typically referred to as Nasdaq. Founded in 1971, Nasdaq hadits origins in the OTC market but is today considered a totally separate entitythat’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formallyrecognized by the SEC as a “listed exchange,” essentially giving it the same statureand prestige as the NYSE.

International Capital Markets

Although U.S. capital markets are by far the world’s largest, there are importantdebt and equity markets outside the United States. In the Eurobond market, cor-porations and governments typically issue bonds denominated in dollars and sellthem to investors located outside the United States. A U.S. corporation might, forexample, issue dollar-denominated bonds that would be purchased by investorsin Belgium, Germany, or Switzerland. Through the Eurobond market, issuingfirms and governments can tap a much larger pool of investors than would begenerally available in the local market.


bid priceThe highest price offered topurchase a security.

ask priceThe lowest price at which asecurity is offered for sale.

Matter of fact

According to the World Federation of Exchanges, the largest stock market in the world, as measured by the total market value of securities listed on that market, is the NYSE

Euronext, with listed securities worth more than $11.8 trillion in the United States and $2.9trillion in Europe. Next largest is the London Stock Exchange, with securities valued at £1.7trillion, which is equivalent to $2.8 trillion given the exchange rate between pounds and dol-lars prevailing at the end of 2009.

NYSE Euronext is the World’s Largest Stock Exchange

Eurobond marketThe market in whichcorporations and governmentstypically issue bondsdenominated in dollars and sellthem to investors locatedoutside the United States.


The foreign bond market is an international market for long-term debt secu-rities. A foreign bond is a bond issued by a foreign corporation or governmentthat is denominated in the investor’s home currency and sold in the investor’shome market. A bond issued by a U.S. company that is denominated in Swissfrancs and sold in Switzerland is a foreign bond. Although the foreign bondmarket is smaller than the Eurobond market, many issuers have found it to be anattractive way of tapping debt markets around the world.

Finally, the international equity market allows corporations to sell blocks ofshares to investors in a number of different countries simultaneously. This marketenables corporations to raise far larger amounts of capital than they could in anysingle market. International equity sales have been indispensable to governmentsthat have sold state-owned companies to private investors.

The Role of Capital Markets

From a firm’s perspective, the role of a capital market is to be a liquid marketwhere firms can interact with investors to obtain valuable external financingresources. From investors’ perspectives, the role of a capital market is to be anefficient market that allocates funds to their most productive uses. This is espe-cially true for securities that are actively traded in broker or dealer markets,where the competition among wealth-maximizing investors determines and pub-licizes prices that are believed to be close to their true value.

The price of an individual security is determined by the interaction betweenbuyers and sellers in the market. If the market is efficient, the price of a stock isan unbiased estimate of its true value, and changes in the price reflect new infor-mation that investors learn about and act on. For example, suppose a certainstock currently trades at $40 per share. If this company announces that sales of anew product have been higher than expected, investors will raise their estimate ofwhat the stock is truly worth. At $40, the stock is a relative bargain, so there willtemporarily be more buyers than sellers wanting to trade the stock, and its pricewill have to rise to restore equilibrium in the market. The more efficient themarket is, the more rapidly this whole process works. In theory, even informationknown only to insiders may become incorporated in stock prices as the Focus onEthics box on page 40 explains.

Not everyone agrees that prices in financial markets are as efficient asdescribed in the preceding paragraph. Advocates of behavioral finance, anemerging field that blends ideas from finance and psychology, argue that stockprices and prices of other securities can deviate from their true values forextended periods. These people point to episodes such as the huge run-up andsubsequent collapse of the prices of Internet stocks in the late 1990s and thefailure of markets to accurately assess the risk of mortgage-backed securities inthe more recent financial crisis as examples of the principle that stock pricessometimes can be wildly inaccurate measures of value.

Just how efficient are the prices in financial markets? That is a question thatwill be debated for a long time. It is clear that prices do move in response to newinformation, and for most investors and corporate managers the best advice isprobably to be cautious when betting against the market. Identifying securitiesthat the market has over- or undervalued is extremely difficult, and very fewpeople have demonstrated an ability to bet against the market correctly for anextended time.


foreign bondA bond that is issued by aforeign corporation orgovernment and isdenominated in the investor’shome currency and sold in theinvestor’s home market.

international equity marketA market that allowscorporations to sell blocks ofshares to investors in a numberof different countriessimultaneously.

efficient marketA market that allocates fundsto their most productive uses asa result of competition amongwealth-maximizing investorsand that determines andpublicizes prices that arebelieved to be close to theirtrue value.

In more depth

To read about The Efficient MarketsHypothesis, go to www.myfinancelab.com


6 REVIEW QUESTIONS2–1 Who are the key participants in the transactions of financial institu-

tions? Who are net suppliers, and who are net demanders?2–2 What role do financial markets play in our economy? What are primary

and secondary markets? What relationship exists between financialinstitutions and financial markets?

2–3 What is the money market? What is the Eurocurrency market?2–4 What is the capital market? What are the primary securities traded in it?2–5 What are broker markets? What are dealer markets? How do they differ?2–6 Briefly describe the international capital markets, particularly the

Eurobond market and the international equity market.2–7 What are efficient markets? What determines the price of an individual

security in such a market?


focus on ETHICS

The Ethics of Insider TradingOn December 27,2001, Martha Stewart

sold nearly 4,000 shares in ImCloneSystems stock. The following day, theFood and Drug Administration deliv-ered some bad news regardingImClone’s cancer drug, Erbitux, andImClone’s stock price dropped substan-tially. It appeared that Martha Stewarthad picked the right time to sell.

Martha Stewart was not the onlyImClone shareholder who was selling.The company’s founder, Sam Waksal,also tried to sell his stock (brokersrefused to execute the sales), as did hisdaughter. The U.S. Securities andExchange Commission and the FederalBureau of Investigation were soon look-ing into the transactions. Sam Waksalultimately received an 87-month prisonsentence and $3 million in fines forinsider trading and tax evasion. MarthaStewart was convicted of conspiracy,obstruction, and making false state-ments to federal investigators andserved 5 months in jail, 5 months ofhome confinement, and 2 years of pro-bation and paid a $30,000 fine. Inaddition, she was forced to resign aschairman and CEO of the company

she had founded, Martha StewartLiving Omnimedia. On the day of herconviction, the company’s shares lost23 percent of their value.

Laws prohibiting insider tradingwere established in the United States inthe 1930s. These laws are designed toensure that all investors have access torelevant information on the same terms.However, many market participantsbelieve that insider trading should bepermitted. Their argument is rooted inthe efficient-market hypothesis (EMH).According to the EMH, stock pricesfully reflect all publicly available infor-mation. Of course, a significant amountof information about every company isnot publicly available. Thus, stockprices may not accurately reflect all thatis known about a company.

Those who argue for allowinginsider trading believe that marketprices influence the allocation ofresources among companies. Firms with higher stock prices find it easier toraise capital, for example. Therefore, it is important that market prices reflectas much information as possible. Ad-vocates of allowing insider tradingargue that investors would quickly

convert inside information into publiclyavailable information if insider tradingwere permitted. If, for example, SamWaksal had been permitted to sell hisstock after learning of the FDA’s deci-sion, market participants might view hisactions and come to the judgment thatImClone’s prospects had dimmed. Ofcourse, the other necessary condition isthat outsiders can observe the stockmarket transactions of insiders.

Interestingly, Eugene Fama, who isviewed by many as the father of theefficient-market hypothesis, does notbelieve that insider trading should bepermitted.a Fama believes that allowinginsider trading creates a moral hazardproblem. For example, if insiders areallowed to trade on proprietary infor-mation, they may have the incentive tohold back information for their personalgain.

3 If efficiency is the goal of financialmarkets, is allowing or disallowinginsider trading more unethical?

3 Does allowing insider trading cre-ate an ethical dilemma for insiders?

in practice

a www.dimensional.com/famafrench/2010/04/qa-is-insider-trading-beneficial.html



2.2 The Financial Crisis

In the summer and fall of 2008, the U.S. financial system, and financial systemsaround the world, appeared to be on the verge of collapse. Troubles in the finan-cial sector spread to other industries, and a severe global recession ensued. In thissection, we outline some of the main causes and consequences of that crisis.

FINANCIAL INSTITUTIONS AND REAL ESTATE FINANCE

In the classic film It’s a Wonderful Life, the central character is George Bailey,who runs a financial institution called the Bailey Building and Loan Association.In a key scene in that movie, a bank run is about to occur and depositors demandthat George return the money that they invested in the Building and Loan.George pleads with one man to keep his funds at the bank, saying:

You’re thinking of this place all wrong, as if I have the money back in a safe. Themoney’s not here. Your money is in Joe’s house. That’s right next to yours—and thenthe Kennedy house, and Mrs. Maklin’s house, and a hundred others. You’re lendingthem the money to build, and then they’re going to pay it back to you as best theycan. What are you going to do, foreclose on them?

This scene offers a relatively realistic portrayal of the role that financial insti-tutions played in allocating credit for investments in residential real estate formany years. Local banks took deposits and made loans to local borrowers.However, since the 1970s, a process called securitization has changed the waythat mortgage finance works. Securitization refers to the process of pooling mort-gages or other types of loans and then selling claims or securities against that poolin a secondary market. These securities, called mortgage-backed securities, can bepurchased by individual investors, pension funds, mutual funds, or virtually anyother investor. As homeowners repay their loans, those payments eventuallymake their way into the hands of investors who hold the mortgage-backed secu-rities. Therefore, a primary risk associated with mortgage-backed securities isthat homeowners may not be able to, or may choose not to, repay their loans.Banks today still lend money to individuals who want to build or purchase newhomes, but they typically bundle those loans together and sell them to organiza-tions that securitize them and pass them on to investors all over the world.

FALLING HOME PRICES AND DELINQUENT MORTGAGES

Prior to the 2008 financial crisis, most investors viewed mortgage-backed securi-ties as relatively safe investments. Figure 2.2 on page 42 illustrates one of the mainreasons for this view. The figure shows the behavior of the Standard & Poor’sCase-Shiller Index, a barometer of home prices in ten major U.S. cities, in eachmonth from January 1987 to February 2010. Historically, declines in the indexwere relatively infrequent, and between July 1995 and April 2006 the index rosecontinuously without posting even a single monthly decline. When house pricesare rising, the gap between what a borrower owes on a home and what the homeis worth widens. Lenders will allow borrowers who have difficulty making pay-ments on their mortgages to tap this built-up home equity to refinance their loansand lower their payments. Therefore, rising home prices helped keep mortgagedefault rates low from the mid-1990s through 2006. Investing in real estate andmortgage-backed securities seemed to involve very little risk during this period.

securitizationThe process of poolingmortgages or other types ofloans and then selling claimsor securities against that poolin the secondary market.

mortgage-backed securitiesSecurities that represent claimson the cash flows generated bya pool of mortgages.

LG 4


In part because real estate investments appeared to be relatively safe, lendersbegan relaxing their standards for borrowers. This led to tremendous growth in acategory of loans called subprime mortgages. Subprime mortgages are mortgageloans made to borrowers with lower incomes and poorer credit histories as com-pared to “prime” borrowers. Often, loans granted to subprime borrowers haveadjustable, rather than fixed, interest rates. This makes subprime borrowers par-ticularly vulnerable if interest rates rise, and many of these borrowers (andlenders) assumed that rising home prices would allow borrowers to refinance theirloans if they had difficulties making payments. Partly through the growth of sub-prime mortgages, banks and other financial institutions gradually increased theirinvestments in real estate loans. In the year 2000, real estate loans accounted forless than 40 percent of the total loan portfolios of large banks. By 2007, real estateloans grew to more than half of all loans made by large banks, and the fraction ofthese loans in the subprime category increased as well.

Unfortunately, as Figure 2.2 shows, home prices fell almost without interrup-tion from May 2006 through May 2009. Over that three-year period, homeprices fell on average by more than 30 percent. Not surprisingly, when home-owners had difficulty making their mortgage payments, refinancing was nolonger an option, and delinquency rates and foreclosures began to climb. By2009, nearly 25 percent of subprime borrowers were behind schedule on theirmortgage payments. Some borrowers, recognizing that the value of their homeswas far less than the amount they owed on their mortgages, simply walked awayfrom their homes and let lenders repossess them.

CRISIS OF CONFIDENCE IN BANKS

With delinquency rates rising, the value of mortgage-backed securities began tofall, and so too did the fortunes of financial institutions that had invested heavilyin real estate assets. In March 2008, the Federal Reserve provided financing forthe acquisition (that is, the rescue) of Bear Stearns by JPMorgan Chase. Later thatyear, Lehman Brothers filed for bankruptcy. Throughout 2008 and 2009, theFederal Reserve, the Bush administration, and finally the Obama administrationtook unprecedented steps to try to shore up the banking sector and stimulate theeconomy, but these measures could not completely avert the crisis.


Jan.

1987

Feb.

2010

Time

250

200

150

100

50

0In

dex

Valu

e

1987 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 2009

FIGURE 2 .2

Housing ValuesStandard & Poor’s Case-Shiller Home Price Index,January 1987 throughFebruary 2010


Figure 2.3 shows the behavior of the Standard & Poor’s Banking Index, anindex that tracks bank stocks. Bank stocks fell 81 percent between January 2008and March 2009, and the number of bank failures skyrocketed. According to theFederal Deposit Insurance Corporation (FDIC), only three banks failed in 2007.In 2008 that number rose by a factor of eight to 25 failed banks, and the numberincreased nearly six times to 140 failures in 2009. While the economy began torecover in 2010, bank failures continued at a rapid pace, with 139 institutionsfailing in the first 10 months of that year.

SPILLOVER EFFECTS AND THE GREAT RECESSION

As banks came under intense financial pressure in 2008, they began to tightentheir lending standards and dramatically reduced the quantity of loans they made.In the aftermath of the Lehman Brothers bankruptcy, lending in the money marketcontracted very sharply. Corporations who had relied on the money market as asource of short-term funding found that they could no longer raise money in thismarket or could do so only at extraordinarily high rates.

As a consequence, businesses began to hoard cash and cut back on expendi-tures, and economic activity contracted. Gross domestic product (GDP) declinedin five out of six quarters starting in the first quarter of 2008, and the economyshed more than 8 million jobs in 2008–2009 as the unemployment rate reached10 percent. Congress passed an $862 billion stimulus package to try to revive theeconomy, and the Federal Reserve pushed short-term interest rates close to 0 per-cent. By late 2009 and early 2010, there were signs that a gradual economicrecovery had begun, but the job market remained stagnant, and most forecastscalled for anemic economic growth.

Perhaps the most important lesson from this episode is how important finan-cial institutions are to a modern economy. By some measures, the 2008–2009recession was the worst experienced in the United States since the GreatDepression. Indeed, there many parallels between those two economic contrac-tions. Both were preceded by a period of rapid economic growth, rising stockprices, and movements by banks into new lines of business, and both involved a


Time

250

300

350

200

150

100

50

0

Index

Valu

e

Jan. 12008

July 12008

Jan. 12009

July 12009

Jan. 12010

May 172010

FIGURE 2 .3

Bank Stock ValuesStandard & Poor’s BankingIndex, January 1, 2008through May 17, 2010


major crisis in the financial sector. Recessions associated with a banking crisistend to be more severe than other recessions because so many businesses rely oncredit to operate. When financial institutions contract borrowing, activity in mostother industries slows down too.

6 REVIEW QUESTIONS2–8 What is securitization, and how does it facilitate investment in real

estate assets?2–9 What is a mortgage-backed security? What is the basic risk associated

with mortgage-backed securities?2–10 How do rising home prices contribute to low mortgage delinquencies?2–11 Why do falling home prices create an incentive for homeowners to

default on their mortgages even if they can afford to make the monthlypayments?

2–12 Why does a crisis in the financial sector spill over into other industries?


2.3 Regulation of Financial Institutions and Markets

The previous section discussed just how vulnerable modern economies are whenfinancial institutions are in a state of crisis. Partly to avoid these types of prob-lems, governments typically regulate financial institutions and markets as muchor more than almost any other sector in the economy. This section provides anoverview of the financial regulatory landscape in the United States.

REGULATIONS GOVERNING FINANCIAL INSTITUTIONS

As mentioned in the previous section, Congress passed the Glass-Steagall Act in1933 during the depths of the Great Depression. The early 1930s witnessed aseries of banking panics that caused almost one-third of the nation’s banks to fail.Troubles within the banking sector and other factors contributed to the worsteconomic contraction in U.S. history, in which industrial production fell by morethan 50 percent, the unemployment rate peaked at almost 25 percent, and stockprices dropped roughly 86 percent. The Glass-Steagall Act attempted to calm thepublic’s fears about the banking industry by establishing the Federal DepositInsurance Corporation (FDIC), which provided deposit insurance, effectivelyguaranteeing that individuals would not lose their money if they held it in a bankthat failed. The FDIC was also charged with examining banks on a regular basisto ensure that they were “safe and sound.” The Glass-Steagall Act also prohibitedinstitutions that took deposits from engaging in activities such as securitiesunderwriting and trading, thereby effectively separating commercial banks frominvestment banks.

Over time, U.S. financial institutions faced competitive pressures from bothdomestic and foreign businesses that engaged in facilitating loans or making

Federal Deposit InsuranceCorporation (FDIC)An agency created by theGlass-Steagall Act thatprovides insurance for depositsat banks and monitors banks toensure their safety andsoundness.

LG 5


loans directly. Because these competitors either did not accept deposits or werelocated outside the United States, they were not subject to the same regulations asdomestic banks. As a result, domestic banks began to lose market share in theircore businesses. Pressure mounted to repeal the Glass-Steagall Act to enable U.S.banks to compete more effectively, and in 1999 Congress enacted and PresidentClinton signed the Gramm-Leach-Bliley Act, which allows commercial banks,investment banks, and insurance companies to consolidate and compete for busi-ness in a wider range of activities.

In the aftermath of the recent financial crisis and recession, Congress passedthe Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010.In print, the new law runs for hundreds of pages and calls for the creation of sev-eral new agencies including the Financial Stability Oversight Council, the Officeof Financial Research, and the Bureau of Consumer Financial Protection. The actalso realigns the duties of several existing agencies and requires existing and newagencies to report to Congress regularly. As this book was going to press, the var-ious agencies affected or created by the new law were writing rules specifyinghow the new law’s provisions would be implemented, so exactly how the new leg-islation will affect financial institutions and markets remains unclear.

REGULATIONS GOVERNING FINANCIAL MARKETS

Two other pieces of legislation were passed during the Great Depression that hadan enormous impact on the regulation of financial markets. The Securities Act of1933 imposed new regulations governing the sale of new securities. That is, the1933 act was intended to regulate activity in the primary market in which securi-ties are initially issued to the public. The act was designed to insure that thesellers of new securities provided extensive disclosures to the potential buyers ofthose securities.

The Securities Exchange Act of 1934 regulates the secondary trading of secu-rities such as stocks and bonds. The Securities Exchange Act of 1934 also createdthe Securities and Exchange Commission (SEC), which is the primary agencyresponsible for enforcing federal securities laws. In addition to the one-time dis-closures required of security issuers by the Securities Act of 1933, the SecuritiesExchange Act of 1934 requires ongoing disclosure by companies whose securitiestrade in secondary markets. Companies must make a 10-Q filing every quarterand a 10-K filing annually. The 10-Q and 10-K forms contain detailed informa-tion about the financial performance of the firm during the relevant period.Today, these forms are available online through the SEC’s website known asEDGAR (Electronic Data Gathering, Analysis, and Retrieval). The 1934 act alsoimposes limits on the extent to which corporate “insiders,” such as senior man-agers, can trade in their firm’s securities.

6 REVIEW QUESTIONS2–13 Why do you think so many pieces of important legislation related to

financial markets and institutions were passed during the GreatDepression?

2–14 What different aspects of financial markets do the Securities Act of1933 and the Securities Exchange Act of 1934 regulate?


Gramm-Leach-Bliley ActAn act that allows businesscombinations (that is, mergers)between commercial banks,investment banks, andinsurance companies, and thuspermits these institutions tocompete in markets that priorregulations prohibited themfrom entering.

Securities Act of 1933An act that regulates the saleof securities to the public viathe primary market.

Securities Exchange Act of 1934An act that regulates thetrading of securities such asstocks and bonds in thesecondary market.

Securities and ExchangeCommission (SEC)The primary governmentagency responsible forenforcing federal securitieslaws.



2.4 Business Taxes

Taxes are a fact of life, and businesses, like individuals, must pay taxes on income.The income of sole proprietorships and partnerships is taxed as the income of theindividual owners; corporate income is subject to corporate taxes.

Regardless of their legal form, all businesses can earn two types of income,ordinary and capital gains. Under current law, these two types of income aretreated differently in the taxation of individuals; they are not treated differentlyfor entities subject to corporate taxes. However, frequent amendments are madeto the tax code, particularly as economic conditions change and when party con-trol of the legislative and executive branches of government shifts.

ORDINARY INCOME

The ordinary income of a corporation is income earned through the sale of goodsor services. Ordinary income in 2010 was taxed subject to the rates depicted inthe corporate tax rate schedule in Table 2.1.

Webster Manufacturing, Inc., a small manufacturer of kitchen knives, has before-tax earnings of $250,000. The tax on these earnings can be found by using thetax rate schedule in Table 2.1:

From a financial point of view, it is important to understand the differencebetween average and marginal tax rates, the treatment of interest and dividendincome, and the effects of tax deductibility.

Marginal versus Average Tax Rates

The marginal tax rate represents the rate at which the next dollar of income istaxed. In the current corporate tax structure, the marginal tax rate is 15 percent

= $22,250 + $58,500 = $80,750

= $22,250 + (0.39 * $150,000)

Total taxes due = $22,250 + 30.39 * ($250,000 - $100,000)4

Example 2.2 3

ordinary incomeIncome earned through thesale of a firm’s goods orservices.

Corporate Tax Rate Schedule

Tax calculation

Range of taxable income Base tax (Marginal rate amount over base bracket)

$ 0 to $ 50,000 $ 0 (15% amount over $ 0)

50,000 to 75,000 7,500 (25 amount over 50,000)

75,000 to 100,000 13,750 (34 amount over 75,000)

100,000 to 335,000 22,250 (39 amount over 100,000)

335,000 to 10,000,000 113,900 (34 amount over 335,000)

10,000,000 to 15,000,000 3,400,000 (35 amount over 10,000,000)

15,000,000 to 18,333,333 5,150,000 (38 amount over 15,000,000)

Over 18,333,333 6,416,667 (35 amount over 18,333,333)*+

*+

*+

*+

*+

*+

*+

*+

:�

TABLE 2 .1

marginal tax rateThe rate at which additionalincome is taxed.

LG 6


if the firm earns less than $50,000. If a firm earns more than $50,000 but lessthan $75,000, the marginal tax rate is 25 percent. As a firm’s income rises, themarginal tax rate that it faces changes as shown in Table 2.1. In the exampleabove, if Webster Manufacturing’s earnings increase to $250,001, the last $1 inincome would be taxed at the marginal rate of 39 percent.

The average tax rate paid on the firm’s ordinary income can be calculatedby dividing its taxes by its taxable income. For most firms, the average tax ratedoes not equal the marginal tax rate because tax rates change with incomelevels. In the example above, Webster Manufacturing’s marginal tax rate is 39 percent, but its average tax rate is 32.3 percent . For very large corporations with earnings in the hundreds of millions or even billions of dollars, the average tax rate is very close to the 35 percent mar-ginal rate in the top bracket because most of the firm’s income is taxed at that rate.

In most of the business decisions that managers make, it’s the marginal taxrate that really matters. To keep matters simple, the examples in this text will usea flat 40 percent tax rate. That means that both the average tax rate and the mar-ginal tax rate equal 40 percent.

Interest and Dividend Income

In the process of determining taxable income, any interest received by the corpo-ration is included as ordinary income. Dividends, on the other hand, are treateddifferently. This different treatment moderates the effect of double taxation,which occurs when the already once-taxed earnings of a corporation are distrib-uted as cash dividends to stockholders, who must pay taxes on dividends up to amaximum rate of 15 percent. Dividends that the firm receives on common andpreferred stock held in other corporations are subject to a 70 percent exclusionfor tax purposes.2 The dividend exclusion in effect eliminates most of the poten-tial tax liability from the dividends received by the second and any subsequentcorporations.

Tax-Deductible Expenses

In calculating their taxes, corporations are allowed to deduct operatingexpenses, as well as interest expense. The tax deductibility of these expensesreduces their after-tax cost. The following example illustrates the benefit of taxdeductibility.

Two companies, Debt Co. and No-Debt Co., both expect in the coming year tohave earnings before interest and taxes of $200,000. During the year, Debt Co.will have to pay $30,000 in interest. No-Debt Co. has no debt and therefore will

Example 2.3 3

($80,750 , $250,000)


2. The 70 percent exclusion applies if the firm receiving dividends owns less than 20 percent of the shares of the firmpaying the dividends. The exclusion is 80 percent if the corporation owns between 20 percent and 80 percent of thestock in the corporation paying it dividends; 100 percent of the dividends received are excluded if it owns more than80 percent of the corporation paying it dividends. For convenience, we are assuming here that the ownership interestin the dividend-paying corporation is less than 20 percent.

average tax rateA firm’s taxes divided by itstaxable income.

double taxationSituation that occurs whenafter-tax corporate earningsare distributed as cashdividends to stockholders, whothen must pay personal taxeson the dividend amount.


Debt Co. had $30,000 more interest expense than No-Debt Co., but Debt Co.’searnings after taxes are only $18,000 less than those of No-Debt Co. This differ-ence is attributable to the fact that Debt Co.’s $30,000 interest expense deductionprovided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No-Debt Co.). This amount can be calculated directly by multiplying the tax rateby the amount of interest expense . Similarly, the$18,000 after-tax cost of the interest expense can be calculated directly by multiplying1 minus the tax rate by the amount of interest expense

.

The tax deductibility of expenses reduces their actual (after-tax) cost to thefirm as long as the firm is profitable. If a firm experiences a net loss in a givenyear, its tax liability is already zero. Even in this case, losses in one year can beused to offset taxes paid on profits in prior years, and in some cases losses can be“carried forward” to offset income and lower taxes in subsequent years. Notethat both for accounting and tax purposes interest is a tax-deductible expense,whereas dividends are not. Because dividends are not tax deductible, their after-tax cost is equal to the amount of the dividend. Thus a $30,000 cash dividend hasan after-tax cost of $30,000.

CAPITAL GAINS

If a firm sells a capital asset (such as stock held as an investment) for more than itpaid for the asset, the difference between the sale price and purchase price iscalled a capital gain. For corporations, capital gains are added to ordinary corpo-rate income and taxed at the regular corporate rates.

Ross Company, a manufacturer of pharmaceuticals, has pretax operating earn-ings of $500,000 and has just sold for $150,000 an asset that was purchased 2 years ago for $125,000. Because the asset was sold for more than its initial pur-chase price, there is a capital gain of $25,000 ($150,000 sale price $125,000initial purchase price). The corporation’s taxable income will total $525,000($500,000 ordinary income plus $25,000 capital gain). Multiplying their taxableincome by 40% produces Ross Company’s tax liability of $210,000.

-

Example 2.4 3

$18,00043(1 - 0.40) * $30,000 =

(0.40 * $30,000 = $12,000)


Debt Co. No-Debt Co.

Earnings before interest and taxes $200,000 $200,000

Less: Interest expense

Earnings before taxes $170,000 $200,000

Less: Taxes (40%)

Earnings after taxes

Difference in earnings after taxes $18,000

$120,000$102,000

80,00068,000

030,000

i

capital gainThe amount by which the saleprice of an asset exceeds theasset’s purchase price.

have no interest expense. Calculation of the earnings after taxes for these twofirms is as follows:


6 REVIEW QUESTIONS2–15 Describe the tax treatment of ordinary income and that of capital gains.

What is the difference between the average tax rate and the marginal taxrate?

2–16 How does the tax treatment of dividend income by the corporationmoderate the effects of double taxation?

2–17 What benefit results from the tax deductibility of certain corporateexpenses?


Summary

THE ROLE OF FINANCIAL INSTITUTIONS AND MARKETS

Chapter 2 described why financial institutions and markets are an integral partof managerial finance. Companies cannot get started or survive without raisingcapital, and financial institutions and markets give firms access to the moneythey need to grow. As we have seen in recent years, however, financial marketscan be quite turbulent, and when large financial institutions get into trouble,access to capital is reduced and firms throughout the economy suffer as a result.Taxes are an important part of this story as well because the rules governing howbusiness income is taxed shape the incentives of firms to make new investments.

REVIEW OF LEARNING GOALS

Understand the role that financial institutions play in managerialfinance. Financial institutions bring net suppliers of funds and net demanderstogether to help translate the savings of individuals, businesses, and govern-ments into loans and other types of investments. The net suppliers of funds aregenerally individuals or households who save more money than they borrow.Businesses and governments are generally net demanders of funds, meaning thatthey borrow more money than they save.

Contrast the functions of financial institutions and financial markets.Both financial institutions and financial markets help businesses raise the moneythat they need to fund new investments for growth. Financial institutions collectthe savings of individuals and channel those funds to borrowers such as busi-nesses and governments. Financial markets provide a forum in which savers andborrowers can transact business directly. Businesses and governments issue debtand equity securities directly to the public in the primary market. Subsequenttrading of these securities between investors occurs in the secondary market.

Describe the differences between the capital markets and the moneymarkets. In the money market, savers who want a temporary place to depositfunds where they can earn interest interact with borrowers who have a short-term need for funds. Marketable securities including Treasury bills, commercialpaper, and other instruments are the primary securities traded in the moneymarket. The Eurocurrency market is the international equivalent of the domesticmoney market.

LG 3

LG 2

LG 1


In contrast, the capital market is the forum in which savers and borrowersinteract on a long-term basis. Firms issue either debt (bonds) or equity (stock)securities in the capital market. Once issued, these securities trade on secondarymarkets that are either broker markets or dealer markets. An important func-tion of the capital market is to determine the underlying value of the securitiesissued by businesses. In an efficient market, the price of a security is an unbiasedestimate of its true value.

Explain the root causes of the 2008 financial crisis and recession. Thefinancial crisis was caused by several factors related to investments in real estate.Financial institutions lowered their standards for lending to prospective home-owners, and institutions also invested heavily in mortgage-backed securities.When home prices fell and mortgage delinquencies rose, the value of the mort-gage-backed securities held by banks plummeted, causing some banks to fail andmany others to restrict the flow of credit to business. That in turn contributed toa severe recession in the United States and abroad.

Understand the major regulations and regulatory bodies that affectfinancial institutions and markets. The Glass-Steagall Act created the FDIC andimposed a separation between commercial and investment banks. The act wasdesigned to limit the risks that banks could take and to protect depositors. Morerecently, the Gramm-Leach-Bliley Act essentially repealed the elements of Glass-Steagall pertaining to the separation of commercial and investment banks. Afterthe recent financial crisis, much debate has occurred regarding the proper regu-lation of large financial institutions.

The Securities Act of 1933 and the Securities Exchange Act of 1934 are themajor pieces of legislation shaping the regulation of financial markets. The 1933act focuses on regulating the sale of securities in the primary market, whereasthe 1934 act deals with regulations governing transactions in the secondarymarket. The 1934 act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws.

Discuss business taxes and their importance in financial decisions.Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capitalgains. The average tax rate paid by a corporation ranges from 15 to 35 percent.Corporate taxpayers can reduce their taxes through certain provisions in the taxcode: dividend income exclusions and tax-deductible expenses. A capital gainoccurs when an asset is sold for more than its initial purchase price; gains areadded to ordinary corporate income and taxed at regular corporate tax rates.(For convenience, we assume a 40 percent marginal tax rate in this book.)

LG 6

LG 5

LG 4


Opener-in-Review

In the chapter opener you read about JPMorgan’s tumultuous ride through the2008 financial crisis, and in the chapter itself you learned about capital marketefficiency. What role do you think market efficiency (or inefficiency) played inthe 10 percent fall of JPMorgan’s share price in a single day?



Self-Test Problem (Solution in Appendix)

ST2–1 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of$280,000 for the year just ended. During the year the firm sold stock that it held inanother company for $180,000, which was $30,000 above its original purchaseprice of $150,000, paid 1 year earlier.a. What is the amount, if any, of capital gains realized during the year?b. How much total taxable income did the firm earn during the year?c. Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total

taxes due.d. Calculate both the average tax rate and the marginal tax rate on the basis of

your findings.

LG 6

Warm-Up Exercises All problems are available in .

E2–1 What does it mean to say that individuals as a group are net suppliers of funds forfinancial institutions? What do you think the consequences might be in financialmarkets if individuals consumed more of their incomes and thereby reduced thesupply of funds available to financial institutions?

E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion designfirm. Your firm needs $10 million to expand production. How do you think theprocess of raising this money will vary if you raise it with the help of a financialinstitution versus raising it directly in the financial markets?

E2–3 For what kinds of needs do you a think firm would issue securities in the moneymarket versus the capital market?

E2–4 Your broker calls to offer you the investment opportunity of a lifetime, the chance toinvest in mortgage-backed securities. The broker explains that these securities areentitled to the principal and interest payments received from a pool of residentialmortgages. List some of the questions you would ask your broker to assess the riskof this investment opportunity.

E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As along-time customer of Reston, your firm has decided to give that assistance. Thequestion you are debating is whether Pruro should take Reston stock with a 5%annual dividend or a promissory note paying 5% annual interest.

Assuming payment is guaranteed and the dollar amounts for annual interest anddividend income are identical, which option will result in greater after-tax incomefor the first year?

LG 1

LG 3

LG 4

LG 6

LG 2

Problems All problems are available in .

P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusivedistributor of a major line of sporting goods. During 2010 the firm earned $92,500before taxes.a. Calculate the firm’s tax liability using the corporate tax rate schedule given in

Table 2.1.b. How much are Tantor Supply’s 2010 after-tax earnings?

LG 6



LG 6

LG 6

LG 6

LG 6

LG 6

LG 6

c. What was the firm’s average tax rate, based on your findings in part a?d. What is the firm’s marginal tax rate, based on your findings in part a?

P2–2 Average corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following:a. Calculate the tax liability, after-tax earnings, and average tax rates for the fol-

lowing levels of corporate earnings before taxes: $10,000; $80,000; $300,000;$500,000; $1.5 million; $10 million; and $20 million.

b. Plot the average tax rates (measured on the y axis) against the pretax incomelevels (measured on the x axis). What generalization can be made concerning therelationship between these variables?

P2–3 Marginal corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following:a. Find the marginal tax rate for the following levels of corporate earnings before taxes:

$15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million.b. Plot the marginal tax rates (measured on the y axis) against the pretax income

levels (measured on the x axis). Explain the relationship between these variables.

P2–4 Interest versus dividend income During the year just ended, Shering Distributors,Inc., had pretax earnings from operations of $490,000. In addition, during the yearit received $20,000 in income from interest on bonds it held in Zig Manufacturingand received $20,000 in income from dividends on its 5% common stock holding inTank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries stock.a. Calculate the firm’s tax on its operating earnings only.b. Find the tax and the after-tax amount attributable to the interest income from

Zig Manufacturing bonds.c. Find the tax and the after-tax amount attributable to the dividend income from

the Tank Industries, Inc., common stock.d. Compare, contrast, and discuss the after-tax amounts resulting from the interest

income and dividend income calculated in parts b and c.e. What is the firm’s total tax liability for the year?

P2–5 Interest versus dividend expense Michaels Corporation expects earnings beforeinterest and taxes to be $40,000 for the current period. Assuming an ordinary taxrate of 40%, compute the firm’s earnings after taxes and earnings available forcommon stockholders (earnings after taxes and preferred stock dividends, if any)under the following conditions:a. The firm pays $10,000 in interest.b. The firm pays $10,000 in preferred stock dividends.

P2–6 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepre-ciable assets, X and Y. Asset X was purchased for $2,000 and will be sold today for$2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. Thefirm is subject to a 40% tax rate on capital gains.a. Calculate the amount of capital gain, if any, realized on each of the assets.b. Calculate the tax on the sale of each asset.

P2–7 Capital gains taxes The following table contains purchase and sale prices for thenondepreciable capital assets of a major corporation. The firm paid taxes of 40% oncapital gains.


a. Determine the amount of capital gain realized on each of the five assets.b. Calculate the amount of tax paid on each of the assets.

P2–8 ETHICS PROBLEM The Securities Exchange Act of 1934 limits, but does not pro-hibit, corporate insiders from trading in their own firm’s shares. What ethical issuesmight arise when a corporate insider wants to buy or sell shares in the firm where heor she works?


LG 5

Asset Purchase price Sale price

A $ 3,000 $ 3,400

B 12,000 12,000

C 62,000 80,000

D 41,000 45,000

E 16,500 18,000

Spreadsheet ExerciseHemingway Corporation is considering expanding its operations to boost its income,but before making a final decision they have asked you to calculate the corporate taxconsequences of their decision. Currently Hemingway generates before-tax yearlyincome of $200,000 and has no debt outstanding. Expanding operations would allowHemingway to increase before-tax yearly income to $350,000. Hemingway can useeither cash reserves or debt to finance its expansion. If Hemingway uses debt, it willhave yearly interest expense of $70,000.

TO DO

Create a spreadsheet to conduct a tax analysis for Hemingway Corporation anddetermine the following:

a. What is Hemingway’s current annual corporate tax liability?b. What is Hemingway’s current average tax rate?c. If Hemingway finances its expansion using cash reserves, what will be its new

corporate tax liability and average tax rate?d. If Hemingway finances its expansion using debt, what will be its new corporate

tax liability and average tax rate?e. What would you recommend that the firm do? Why?

Visit www.myfinancelab.com for Chapter Case: The Pros and Cons of Being PubliclyListed, Group Exercises, and numerous online resources.


Merit Enterprise Corp.

Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing herpresentation one last time before her upcoming meeting with the board of direc-

tors. Merit’s business had been brisk for the last two years, and the company’s CEOwas pushing for a dramatic expansion of Merit’s production capacity. Executing theCEO’s plans would require $4 billion in capital in addition to $2 billion in excesscash that the firm had built up. Sara’s immediate task was to brief the board onoptions for raising the needed $4 billion.

Unlike most companies its size, Merit had maintained its status as a privatecompany, financing its growth by reinvesting profits and, when necessary, borrowingfrom banks. Whether Merit could follow that same strategy to raise the $4 billionnecessary to expand at the pace envisioned by the firm’s CEO was uncertain, thoughit seemed unlikely to Sara. She had identified two options for the board to consider:

Option 1: Merit could approach JPMorgan Chase, a bank that had served Meritwell for many years with seasonal credit lines as well as medium-term loans. Lehnbelieved that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,but it could probably gather a group of banks together to make a loan of this magni-tude. However, the banks would undoubtedly demand that Merit limit further bor-rowing and provide JPMorgan with periodic financial disclosures so that they couldmonitor Merit’s financial condition as it expanded its operations.

Option 2: Merit could convert to public ownership, issuing stock to the publicin the primary market. With Merit’s excellent financial performance in recent years,Sara thought that its stock could command a high price in the market and that manyinvestors would want to participate in any stock offering that Merit conducted.

Becoming a public company would also allow Merit, for the first time, to offeremployees compensation in the form of stock or stock options, thereby creatingstronger incentives for employees to help the firm succeed. On the other hand, Saraknew that public companies faced extensive disclosure requirements and other regu-lations that Merit had never had to confront as a private firm. Furthermore, withstock trading in the secondary market, who knew what kind of individuals or insti-tutions might wind up holding a large chunk of Merit stock?

TO DO

a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are themost positive aspects of this option, and what are the biggest drawbacks?

b. Do the same for option 2.c. Which option do you think Sara should recommend to the board and why?

54

Integrative Case 1


7491 Gitman Ch02 pp030-054 -...

Documents

Transcript of 7491 Gitman Ch02 pp030-054 -...