Chapter 2

The Financial Market Environment

N Chapter Summary
In this chapter you will learn about finance institutions and finance markets. You will learn the difference between primary and secondary markets, money and capital markets, and dealer and broker markets. You will learn about how the government regulates these markets and about how a finance crisis can occur. There will also be a discussion on business taxes and their importance in financial decisions. By the end

LG .

of this chapter, you will have a much better understanding of the financial market environment. Understand the role that financial institutions play in managerial finance.
Financial institutions bring net suppliers of funds and net demanders of funds together to help

translate the savings of individuals, businesses, and governments into loans and other types of investments. The net suppliers of funds are generally individuals or households who save more money than they borrow. Businesses and governments are generally net demanders of funds, meaning that they
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 money they need to fund new investments for growth. Financial institutions collect the savings of individuals and channel those funds to borrowers such as businesses and governments. Financial markets provide a forum in which savers and borrowers can transact business directly. Businesses and governments issue debt and equity securities directly to the public in the primary market. Subsequent trading of these securities between investors occurs in the secondary market. Describe the differences between the capital markets and the money markets. In the money
market, savers who want a safe, temporary place to deposit funds where they can earn interest

interact with borrowers who have a short-term need for funds, generally a year or less. In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis (more than a year). ExpVain the root causes of the 2008 financial crisis and recession. The financial crisis was caused by several factors related to investments in real estate. Financial institutions lowered their standards for lending to prospective homeowners, and institutions also invested heavily in mortgage-backed securities. When home prices fell and mortgage delinquencies rose, the value of the mortgagebacked securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business. That in turn contributed to a severe recession in the United States and abroad.

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Understand the major regulations and regulatory bodies that affect_financial and markets. The Glass-Steagall Act created the FDIC and imposed a separation between commercial and investment banks. The act was designed to limit the risks banks could take and to protect depositors. Recently, the Gramm-Leach-Bliley Act essentially repealed the elements of GlassSteagall pertaining to the separation of commercial and investment banks. After the recent financial crisis, much debate has occurred regarding the proper regulation of large financial
institutions

institutions.

The Securities Act of 1933 and the Securities Exchange Act of 1 934 are the major pieces of legislation shaping the regulation of financial markets. The 1933 act focuses on regulating the sale of securities in the primary market, whereas the 1934 act deals with regulations governing transactions in the secondary market. The 1934 act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws.

LG 6

Discuss business taxes and their importance in,fnancial decisions. Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capital gains (when an asset is sold for more than its initial purchase price). 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 tax code: dividend income exclusions and taxdeductible expenses.

Chapter Notes
The Role of Financial Institutions in Managerial Finance
LG
1 Firms can obtain funds from external sources in three ways: 1. Financial institutions serve as intermediaries, accepting savings and transferring them to those who need funds 2. Financial markets, which are organized forums in which the suppliers and demanders of various types of funds can make transactions 3. Private placement is the sale of a new security directly to an investor or group of investors The net suppliers of funds are generally individuals or households who save more money than they borrow. Businesses and governments are generally net demanders of funds, meaning that they borrow more money than they save. The major financial institutions in the U.S. economy are commercial banks, savings and loans, credit unions, savings banks, insurance companies, mutual funds, and pension funds. Investment banks are institutions that assist companies in raising capital, advise firms on major transactions, and engage in trading and market making activities. The shadow banking system, which grew in the 1990s, is when a group of institutions engage in lending activities, like traditional banks, but do not accept deposits and therefore, are not subject to the same regulations as traditional banks.

Contrast Functions of Financial Institutions and Financial Markets

LE1
2

Both financial institutions and financial markets help businesses raise the money they need to fund new investments for growth. However, financial institutions collect the savings of individuals and channel those funds to borrowers such as businesses and governments, whereas financial markets provide a forum in which savers and borrowers can transact business directly. Businesses and governments issue debt and equity securities directly to the public in the primary market. Subsequent trading of these securities between investors occurs in the secondary market.
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Differences between the Capital Markets and the Money Markets

LG 3 Two key financial markets are the money market and the capital market. In the money market, the investors are savers who want a safe, temporary place to deposit funds where they can earn interest and interact with borrowers who have a short-term need for funds, generally a year or less. Marketable securities including Treasury bills, commercial paper, and other instruments are the primary securities traded in the money market. The Eurocurrency market is the international equivalent of the domestic money market. In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis, more than a year. Firms issue either debt (bonds) or equity (common and preferred stock) securities in the capital market. The Eurobond market typically issues bonds denominated in dollars and sells them to investors located outside the United States. The international equity market allows corporations to sell blocks of shares to investors in a number of different counties simultaneously. Once issued, these securities trade on secondary markets that are either broker markets or dealer markets. In it broker market, for the trade to take place, the buyer and seller are brought together and the securities change hands on the floor of an exchange. In the dealer market, the buyer and seller are never brought together directly; instead market makers execute the orders through an electronic trading platform. An important function of the capital market is to determine the underlying value of the securities issued by businesses. In an efficient market, the price of a security is an unbiased estimate of its true value. An efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and thus as investors learn new information it is reflected quickly in stock prices.

Root Causes of the 2008 Financial Crisis and Recession 0

r4
The 2008 financial crisis was caused by several factors related to investments in real estate that spread to other industries and resulted in it severe global recession. Securitization is the process of pooling mortgages or other types of loans and then selling claims or securities against that pool in the secondary market. These securities are called mortgage-backed securities and can be purchased by virtually any investor. The basic risk of these securities is that homeowners may not be able or may not choose to repay their loans. When home prices are rising and borrowers are having difficulty making payments on their mortgages, lenders allow borrowers to tap this built-up equity and refinance. When home prices are falling there is no built-up equity, and in fact the price of the home may fall below the value of the mortgage, causing borrowers to walk away from their homes. Securitization made it easier for banks to lend money because they could pass the risk on to other investors. Soon financial institutions lowered their standards for lending to prospective homeowners, and institutions also invested heavily in mortgage-backed securities. When home prices fell and mortgage delinquencies rose, the value of the mortgage-backed securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business. That in turn contributed to a severe recession in the United States and abroad.

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Major Regulations and Regulatory Bodies that Affect Institutions and Markets
LG 5 Governments regulate financial institutions and markets to avoid finance crisis. In 1933, during the Great Depression, the Glass-Steagall Act created the FDIC and imposed a separation between commercial and investment banks. The act was designed to limit the risks that banks could take and to protect depositors. Recently, the Gramm-Leach-Bliley Act essentially repealed the elements of Glass-Steagall pertaining to the separation of commercial and investment banks. After the recent financial crisis, much debate has occurred regarding the proper regulation of large financial institutions. The Securities Act of 1933 and the Securities Exchange Act of 1934 are the major pieces of legislation shaping the regulation of financial markets. The 1933 act focuses on regulating the sale of securities in the primary market, whereas the 1934 act deals with regulations governing transactions in the secondary market. The 1934 act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws.

Business Taxes and Their Importance in Financial Decisions

LG

Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capital gains. Ordinary income is income earned through the sale of goods or services. The more is earned, the greater the percentage of tax owed. The average tax rate paid by corporations ranges from 15 to 35 percent. Corporate taxpayers can reduce their taxes through certain provisions in the tax code: dividend income exclusions and taxdeductible expenses. The average tax is the amount of tax paid divided by total income. The marginal tax rate is the percentage of tax owed on the next dollar earned. Marginal rates usually exceed average rates. Capital gains are income earned due to the sale of an asset for more than its initial purchase price. Currently, capital gains are added to ordinary income and taxed at the regular corporate rate, with the maximum rate of 39%. To simplify tax calculations, a fixed rate of 40% will be used throughout the remaining chapters in this text regardless of whether it is ordinary or capital gain income.

Sample Problems and Solutions

Example 1. Income tax calculation
A firm has $1,000,000 in ordinary and capital gains income. What will this firm owe in taxes according to the figures in Table 2.1 of the text? Calculate the average tax rate and the marginal tax rate on the basis of your findings.

Solution
Total taxes due = $113,900+ [0.34 x ($1,000,000- $335,000)] Total taxes clue = $113,900+ (0.34 x $665,000) Total taxes due = $1 13,900+ $226,100 = $340,000 Average tax rate = $340,000/$ 1,000,000 = 0.34 = 34% Marginal tax rate = 34%

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Example 2. Interest versus dividend expense

A firm expects earnings before interest and taxes to be $60,000 for this period. Assuming an ordinary tax rate of 40%, compute the firm's earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions: a. The firm pays $20,000 in interest. b. The firm pays $20,000 in preferred stock dividends.

Solution
a. Taxes of 40% will be paid on earnings before interest and taxes of $60,000 less the interest of $20,000. Therefore the taxes will be $16,000 (60,000 20,000) x 0.4]. So the earnings after taxes and the earnings available for common shareholders is $24,000 [ = 60,000 20,000 16,000]. b. Taxes of 40% will be paid on the earnings before interest and taxes of $60,000. Therefore the taxes will be $24,000 [= 60,000 x 0.4]. So the earnings available after taxes is $36,000 [60,000 24,000].
The earnings available to common shareholders is the earnings available after taxes less the preferred

stock dividends, $16,000 [= 36,000 20,0001. We can see from the above that because interest is a tax deductible expense the earnings available to shareholders is greater when a firm pays interest rather than preferred dividends.

Study Tips
1. This chapter contains many terms and definitions. It is important to learn these terms to fully understand the financial environment in which the rest of the book takes places. Make sure you know the differences between financial institutions and finance markets, between the primary and secondary market, and between the money and capital market. Understanding when and why different regulations were written will help you understand the current financial environment. Although it is important to understand how corporate taxes are calculated with a table as explained in this chapter, remember that throughout the rest of the book we assume a 40% marginal tax rate.

2.

Student Notes

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Gitman/Zutter Principles of Managerial Finance, Thirteenth Edition

s Sample Exam-Chapter 2
True/False
T F T F T F T F T F T F T F T F T F I. Individuals or households are generally the net suppliers of funds and businesses and governments are generally the net demanders of funds. 2. Businesses and governments issue debt and equity directly to the public in the secondary market. 3. Financial markets are organized forums in which the suppliers and demanders of various types of funds can make transactions. 4. Capital markets are for investors who want a safe temporary place to deposit funds where they can earn interest and interact with borrowers who have a short-term need for funds. 5. Money markets are markets for long-term funds such as bonds and equity. 6. An efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors. 7. Securitization is the process of pooling mortgages or other types of loans and selling the claims or securities against that pool in the secondary market. 8. Securitization made it harder for banks to lend money because they could pass the risk on to other investors. 9. The Glass-Steagall Act was imposed to encourage commercial and investment banks to combine and work together.

T F 10. The Securities Act of 1933 focuses on regulating the sale of securities in the primary market, whereas the 1934 act deals with regulations governing the transactions in the secondary market. T F 11. Corporate tax rates apply only to ordinary income, not capital gains. T F 12. Capital gains are income earned due to an increase in the value of the asset. T F 13. The average tax is the amount of the tax paid divided by total income.

Multiple Choice
1. Successful firms can obtain funds from which of the following external sources:
a. Financial institutions

b. Financial markets c. Private placement d. All of the above

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2.

serve as intermediaries channeling the savings of individuals, businesses, and governments into loans and investments. a. Financial markets b. Financial institutions c. Securities Exchanges d. OTC Markets
are generally the net supplier's of funds for financial institutions.

3.

a. b. c. d. 4. a. b. c. d. 5.

Individuals Governments Businesses all of the above are generally the net demanders of funds for financial institutions. Individuals and governments Individuals and businesses Businesses and governments Governments

provide savers with a secure place to invest funds and offer both individuals and companies loans to finance investments. a. b. c. d. Investment banks Securities exchanges Mutual funds Commercial banks

6.

assist companies in raising capital, advise firms on major transactions such as mergers or financial restructuring, and engage in trading and market-making activities. a. Investment banks b. Securities exchanges c. Mutual funds d. Commercial banks

7. The Glass-Steagall Act a. allowed commercial and investment banks to engage in the same activities. b. created the Securities Exchange Commission. c. created the Federal Deposit Insurance program and separated the activities of commercial and investment banks. d. was intended to regulate the activities in the primary market. 8. are forums in which suppliers of funds and demanders of fiords can transact business directly. a. Shadow banking systems b. Financial markets c. Commercial banks
d. Financial institutions

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9. The sale of a new security directly to an investor or group of investors is called a. b. c. d. the secondary market. the primary market. the capital market. a private placement. market is where

10. The market is where securities are initially issued and the pre-owned securities (not new issues) are. traded. a. primary; secondary b. secondary; primary c. money; capital d. primary; money

11. The market is created by a financial relationship between suppliers and demanders of shortterm funds, whereas the market enables suppliers and demanders of long-term funds to
make transactions.

a. capital; money b. money; capital c. primary; secondary d. secondary; primary 12. The key capital market securities are: a. Negotiable Certificates of Deposit b. Commercial Paper c. U.S. Treasuries d. Bonds and Common and Preferred Stock 13. Ina market, the buyer and seller are brought together to trade securities in an organization called a. dealer; securities market b. broker; over-the-coulter market
c. broker; securities market

d. dealer; over-the-counter market 14. In a market, the buyer and seller are not brought together directly but instead have their orders executed on the a. dealer; securities market b. broker; over-the-counter market c. broker; securities market d. dealer; over-the-counter market 15. An efficient market is one where a. prices of stocks move up and down widely without any apparent reason. b. prices of stocks remain steady for long periods of time. c. prices of stocks are steadily decreasing for long periods of time. d. prices of stocks incorporate new information quickly and adjust appropriately to their true value.

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16. An implication of the Efficient Market Hypothesis is that it is very hard for an actively managed mutual fund to earn above average returns. This is true for all of the following reasons EXCEPT: a. predictable information is already incorporated into stock prices. b. new information is by definition unpredictable, thus hard to incorporate into stock prices. c. actively managed mutual funds typically charge fees of about 1.5%. d. index funds make no attempt to analyze stocks.
17

The process of pooling mortga ges or other types of loans and then selling claims or Securities against that pool in the secondary market is called a. b. c. d. refinancing. securitization. private placement. pooling.

18. The primary risk of mortgage-backed securities is: a. that prices of housing will increase. b. that interest rates will go clown. c. that the government will not be able to meet their guarantees on the cash flows. d. that homeowners may not be able or choose not to repay their loans. 1 9. A crisis in the financial sector often spills over into other industries because when financial institutions borrowing, activity in most other industries also a. increase; slows clown b. contract; slows down c. increase; increase
d. contract; increase

20. The Federal Deposit Insurance Corporation (FDIC) a. guarantees individuals will not lose any money held at a bank that fails. b. guarantees individuals will not lose any money, up to a specified amount, held at a bank that fails. c. guarantees individuals will not lose any money held at any type of financial institution that fails. d. guarantees individuals will not lost any money, up to a specified amount, held at type of financial institution that fails. 21. The Gramni-Leach-Biley Act a. allows business combinations between commercial banks, investment banks, and insurance
companies.

b. does not allow business combinations between commercial banks, investment banks, and
insurance companies.

c. allows business combinations between commercial banks and investment banks, but not insurance companies. d. was signed right after the Great Depression because of the financial crisis.

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Gilman/Zutter Principles of Managerial Finance, Thirteenth Edition

22.

regulates the secondary market and created the Securities Exchange Commission (SEC). a. The Securities Act of 1933 b. The Gramm-Leach-Biley Act c. The Securities Exchange Act of 1934 d. The Glass-Steagall Act

23. Use the tax rate schedule in Table 2.1 to find the tax on a company who has before tax earnings of $300,000. a. $117,000

b. $78,000
c. $139,250 d. $100,250 24. Use the tax rate schedule on Table 2.1 to find the marginal tax rate on a company who has before-tax earnings of $300,000. a. 15% b. 39%

c. 34%
d. 25% 25. Use the tax rate schedule on Table 2.1 to find the average tax rate on a company who has before-tax

earnings of $300,000.
a. 33% b. 46% c.

26% d. 39%

26. If two firms have the same earnings before interest and taxes and Firm A pays $10,000 in interest expenses but no preferred dividend and Firm B pays no interest expense but $10,000 in preferred dividends, which firm has the most earnings available for common share holders? a. Firm A b. Firm B c. They will be equal d. Need more information to determine

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Essay
1 Describe the differences between the money market and the capital market.

2.

Contrast broker and dealer markets.

3.

Explain the root causes of the recent financial crisis and recession.

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Gitman/Zutter Principles o Managerial Finance, Thirteenth Edition

Chapter 2 Answer Sheet

True/False 1.T 2. F Multiple Choice 1.D 2.B 16.D 17.B 18.D 19.B 20.B 21 A 22.CC 23.D 24.B 25.A 26.A

3.T
4.F 5. F 6.T 7.T 8.F 9.F 10.T 11.F 12.T 13.T

3.A
4.C 5.B 6.A 7.C 8.B 9.D 10.A 11.B 12.D 13.C 14.D 15.D

$22250 + 039 x ($300000,,

S 100,000)

($22,250 + 0.39 x ($300,000

$100,000))/$300,000

Essay
1 In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have a short-term need for funds, generally a year or less. In contrast, the capital market is the forum in which savers and borrowers interact on it long-term basis, more than a year. The key difference between broker and dealer markets is the way in which trades are executed. The broker market consists of national and regional securities exchanges. With the assistance of brokers, the buyer and seller are simultaneously brought together on the floor of this exchange. In contrast, in the dealer market there are essentially two trades in every transaction, with the buyer purchasing shares from a dealer and the seller selling shares to a dealer. Broker markets include the New York Stock Exchange, while the dealer market includes Nasdaq and the over-the-counter market. Since investors are risk averse, a security must provide a higher level of return to induce investors to accept a higher level of risk. As a result, increasing risk will be associated with
increasing return.

2.

3.

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

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