Chapter 2

The Financial
Market
Environment

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All rights reserved.
 Financial Institutions & Markets

Firms that require funds from external sources can obtain

them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

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 Financial Institutions &
Markets: Financial Institutions
• Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into
loans or investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

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 Commercial Banks, Investment Banks,
and the Shadow Banking System

• Commercial banks are institutions that provide savers

with a secure place to invest their funds and that offer
loans to individual and business borrowers.
• Investment banks are institutions that assist companies
in raising capital, advise firms on major transactions such
as mergers or financial restructurings, and engage in
trading and market making activities.

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 Commercial Banks, Investment Banks,
and the Shadow Banking System (cont.)

• The Glass-Steagall Act was an act of Congress in 1933

that created the federal deposit insurance program and
separated the activities of commercial and investment
banks.
– Repealed in the late 1990s.
• The shadow banking system describes a group of
institutions that engage in lending activities, much like
traditional banks, but these institutions do not accept
deposits and are therefore not subject to the same
regulations as traditional banks.

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 Financial Institutions &
Markets: Financial Markets
• Financial markets are forums in which suppliers of funds
and demanders of funds can transact business directly.
• Transactions in short term marketable securities take place
in the money market while transactions in long-term
securities take place in the capital market.
• A private placement involves the sale of a new security
directly to an investor or group of investors.
• Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds or
stocks to the general public.

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 Financial Institutions & Markets:
Financial Markets (cont.)
• The primary market is the financial market in which
securities are initially issued; the only market in which the
issuer is directly involved in the transaction.
• Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded.

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 Figure 2.1
Flow of Funds

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 The Money Market

• The money market is created by a financial relationship

between suppliers and demanders of short-term funds.
• Most money market transactions are made in marketable
securities which are short-term debt instruments, such as
U.S. Treasury bills, commercial paper, and negotiable
certificates of deposit issued by government, business,
and financial institutions, respectively.
• Investors generally consider marketable securities to be
among the least risky investments available.

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 The Money Market (cont.)

• The international equivalent of the domestic (U.S.) money

market is the Eurocurrency market.
• The Eurocurrency market is a market for short-term bank
deposits denominated in U.S. dollars or other marketable
currencies.
• The Eurocurrency market has grown rapidly mainly
because it is unregulated and because it meets the needs
of international borrowers and lenders.

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 The Capital Market

• The capital market is a market that enables suppliers and

demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term debt)
and both common and preferred stock (equity, or
ownership).
– Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a diverse
group of lenders.
– Common stock are units of ownership interest or equity in a
corporation.
– Preferred stock is a special form of ownership that has features of
both a bond and common stock.

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 Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which the two
sides of a transaction, the buyer and seller, are brought
together to trade securities.
– Trading takes place on centralized trading floors.
– Examples include: NYSE Euronext, American Stock Exchange

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 Broker Markets and
Dealer Markets (cont.)
Dealer markets are markets in which the buyer and seller are
not brought together directly but instead have their orders
executed by securities dealers that “make markets” in the given
security.
– The dealer market has no centralized trading floors. Instead, it is
made up of a large number of market makers who are linked
together via a mass-telecommunications network.
The Nasdaq market is one example (National Association of Securities Dealers
Automated Quotation System)

As compensation for executing orders, market makers make

money on the spread (bid price – ask price).
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 Matter of Fact

NYSE Euronext is the World’s Largest Stock Exchange

– According to the World Federation of Exchanges, NYSE
Euronext is the largest stock market in the world, as measured
by the total market value of securities listed on that market.
– NYSE Euronext has listed securities worth more than $11.8
trillion in the U.S. and $2.9 trillion in Europe.
– Next largest is the London Stock Exchange with securities
valued at £1.7 trillion, which is equivalent to $2.8 trillion given
the exchange rate between pounds and dollars prevailing at the
end of 2009.

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 International Capital Markets

• In the Eurobond market, corporations and governments

typically issue bonds denominated in dollars and sell
them to investors located outside the United States.
• The foreign bond market is a market for bonds issued by
a foreign corporation or government that is denominated
in the investor’s home currency and sold in the investor’s
home market.
• The international equity market allows corporations to
sell blocks of shares to investors in a number of different
countries simultaneously.

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 The Role of Capital Markets

• From a firm’s perspective, the role of capital markets is to be a

liquid market where firms can interact with investors in order to
obtain valuable external financing resources.
• From investors’ perspectives, the role of capital markets is to be an
efficient market that allocates funds to their most productive uses.
• An efficient market allocates funds to their most productive uses
as a result of competition among wealth-maximizing investors and
determines and publicizes prices that are believed to be close to
their true value.

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 The Role of Capital Markets
(cont.)
• Advocates of behavioral finance, an emerging field that
blends ideas from finance and psychology, argue that
stock prices and prices of other securities can deviate
from their true values for extended periods.
• These people point to episodes such as the huge run up
and subsequent collapse of the prices of Internet stocks in
the late 1990s, or the failure of markets to accurately
assess the risk of mortgage-backed securities in the more
recent financial crisis, as examples of the principle that
stock prices sometimes can be wildly inaccurate measures
of value.

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 Focus on Ethics

The Ethics of Insider Trading

– Martha Stewart was convicted of conspiracy, obstruction, and making false
statements to federal investigators and served 5 months in jail, 5 months of
home confinement, 2 years of probation, and a $30,000 fine.
– Laws prohibiting insider trading were established in the United States in the
1930s. These laws are designed to ensure that all investors have access to
relevant information on the same terms.
– However, many market participants believe that insider trading should be
permitted.
– If efficiency is the goal of financial markets, is allowing or disallowing
insider trading more unethical?
– Does allowing insider trading create an ethical dilemma for insiders?

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 Review Questions
2–1 Who are the key participants in the transactions of financial institutions?
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 financial
institutions 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?

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Financial Crisis
 Financial crisis broadly refers to;
 disruptions in financial markets causing constraint to the flow of
credit to families and businesses and,
 consequently having an adverse effect on the real economy of
goods and services.
 The term is generally used to describe a situation in
which;
 investors unexpectedly lose a substantial amount of their
investments, and
 financial institutions suddenly lose a significant proportion of
their value.
 Financial crises include, among others;
 stock market crashes,
 financial bubbles,
20
 currency crises, and
 sovereign defaults.
 The Financial Crisis: Financial
Institutions and Real Estate Finance
• Securitization is the process of pooling mortgages or
other types of loans and then selling claims or securities
against that pool in a secondary market.
• Mortgage-backed securities represent claims on the cash
flows generated by a pool of mortgages and can be
purchased by individual investors, pension funds, mutual
funds, or virtually any other investor.
• A primary risk associated with mortgage-back securities
is that homeowners may not be able to, or may choose not
to, repay their loans.

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 The Subprime Mortgage Dilemma
It is believed that every economic crisis is the product of cheap
credit; low interest rates create demand for loans that cannot be
repaid when interest rates subsequently rise.
Lower interest rates in the United States meant that mortgages
became more affordable and more in demand.
Chapra (2009) points out that in such an environment “loan
volume gained greater priority over loan quality” and ordinary
investors were enticed to live beyond their means.
As interest rates began to rise, new-home affordability and the
ability to repay existing loans have sharply plummeted.
The problem was exacerbated by the complexity of products
that have been created by intermediary players that sought to
pass the entire risk of default to the final purchasers.
22
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 The Financial Crisis: Falling Home Prices
and Delinquent Mortgages (Figure 2.2)

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 The Financial Crisis: Crisis of
Confidence in Banks (Figure 2.3)

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 The Financial Crisis: Spillover
Effects and the Great Recession
• As banks came under intense financial pressure in 2008,
they tightened their lending standards and dramatically
reduced the quantity of loans they made.
• Corporations found that they could no longer raise money
in the money market, or could only do so at
extraordinarily high rates.
• As a consequence, businesses began to hoard cash and cut
back on expenditures, and economic activity contracted.

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 Implications of the Global Financial Crisis
A limited subprime mortgage impasse in the US real estate grew
to be the world’s biggest financial crisis since the 1930s.
Every section of the globe have been some how affected by the
crisis, as it has hit almost every sector of the world’s economy.
World economies have yet to devise prudent strategies to deal
with the crisis.
Conventional financial institutions, by and large, were the first to
feel the full impact of the crisis they had initiated.
The year 2008 was packed with unparalleled events that have
created mass uncertainty, such as:
– a sharp decline in global equity markets,
– the failure or collapse of numerous global financial institutions,
– governments of a number of industrialized countries allocating in
excess of $7 trillion for a bailout and liquidity injections to revive their
28
economies,
 Review Questions
2–8 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 monthly payments?
2–12 Why does a crisis in the financial sector spill over into
other industries?

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 Business Taxes

• Both individuals and businesses must pay taxes on income.

• The income of sole proprietorships and partnerships is taxed as the
income of the individual owners, whereas corporate income is
subject to corporate taxes.
• Both individuals and businesses can earn two types of income—
ordinary income and capital gains income.
• Under current law, tax treatment of ordinary income and capital
gains income change frequently due frequently changing tax laws.

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 Table 2.1
Corporate Tax Rate Schedule

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 Business Taxes:
Ordinary Income
Ordinary income is earned through the sale of a firm’s goods
or services and is taxed at the rates depicted in Table 2.1 on
the previous slide.

Example
Weber Manufacturing Inc. has before-tax earnings of $250,000.
Tax = $22,500 + [0.39  ($250,000 – $100,000)]
Tax = $22,500 + (0.39  $150,000)
Tax = $22,500 + $58,500 = $80,750

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 Business Taxation: Marginal
versus Average Tax Rates
• A firm’s marginal tax rate represents the rate at which
additional income is taxed.
• The average tax rate is the firm’s taxes divided by
taxable income.

Example
What are Webster Manufacturing’s marginal and average tax
rates?
Marginal Tax Rate = 39%
Average Tax Rate = $80,750/$250,000 = 32.3%

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 Business Taxation:
Interest and Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion moderates the effect of double taxation,
which occurs when after-tax corporate earnings are
distributed as cash dividends to stockholders, who then
must pay personal taxes on the dividend amount.
• Unlike dividend income, all interest income received is
fully taxed.

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 Business Taxation:
Tax-Deductible Expenses
• In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.

Example
Two companies, Debt Co. and No Debt Co., both
expect in the coming year to have EBIT of $200,000.
During the year, Debt Co. will have to pay $30,000 in
interest expenses. No Debt Co. has no debt and will
pay not interest expenses.
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 Business Taxation:
Tax-Deductible Expenses (cont.)

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 Business Taxation:
Tax-Deductible Expenses (cont.)
• As the example shows, the use of debt financing can
increase cash flow and EPS, and decrease taxes paid.
• The tax deductibility of interest and other certain
expenses reduces their actual (after-tax) cost to the
profitable firm.
• It is the non-deductibility of dividends paid that results in
double taxation under the corporate form of organization.

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 Business Taxation: Capital
Gains
• A capital gain is the amount by which the sale price of an
asset exceeds the asset’s purchase price.
• For corporations, capital gains are added to ordinary
income and taxed like ordinary income at the firm’s
marginal tax rate.
Example
Ross Company has just sold for $150,000 and asset
that was purchased 2 years ago for $125,000. Because
the asset was sold for more than its initial purchase
price, there is a capital gain of $25,000 ($150,000 -
$125,000).
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 Review Questions

2–15 Describe the tax treatment of ordinary income and that of

capital gains. What is the difference between the average
tax rate and the marginal tax rate?
2–16 How does the tax treatment of dividend income by the
corporation moderate the effects of double taxation?
2–17 What benefit results from the tax deductibility of certain
corporate expenses?

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 Self-Test Problem

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 in another company for $180,000, which was $30,000 above its
original purchase price 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.

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 Warm-Up Exercises

E2–1 What does it mean to say that individuals as a group are net suppliers
of funds for financial institutions? What do you think the consequences
might be in financial markets if individuals consumed more of their
incomes and thereby reduced the supply of funds available to financial
institutions?
E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy
fashion design firm. Your firm needs $10 million to expand production.
How do you think the process of raising this money will vary if you raise it
with the help of a financial institution 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 money market versus the capital market?

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 Warm-Up Exercises

E2–4 Your broker calls to offer you the investment opportunity of a lifetime,
the chance to invest in mortgage-backed securities. The broker explains
that these securities are entitled to the principal and interest payments
received from a pool of residential mortgages. List some of the questions
you would ask your broker to assess the risk of this investment
opportunity.
E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial
assistance. As a long-time customer of Reston, your firm has decided to
give that assistance. The question 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 and dividend income are identical,
which option will result in greater after-tax income for the first year?

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 Problems

P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as

the exclusive distributor of a major line of sporting goods. During 2010 the
firm earned $92,500 before 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?
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?

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 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 following 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 income levels (measured on the x axis). What
generalization can be made concerning the relationship
between these variables?

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 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.

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 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 year
it received $20,000 in income from interest on bonds it held in Zig Manufacturing
and received $20,000 in income from dividends on its 5% common stock holding
in Tank 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?

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 P2–5

Interest versus dividend expense Michaels Corporation

expects earnings before interest and taxes to be $40,000 for
the current 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 $10,000 in interest.
b. The firm pays $10,000 in preferred stock dividends.

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 P 2.6

Capital gains taxes Perkins Manufacturing is considering the

sale of two nondepreciable 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. The firm 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.

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 P 2.7

Capital gains taxes The following table contains purchase and sale prices
for the nondepreciable capital assets of a major corporation. The firm paid
taxes of 40% on capital 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.

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