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HUZSOB
Introduction to Managerial Finance
The Financial Environment: Markets, Institutions, Interest Rates and Taxes
Besley: Chapter 2
Besley Ch. 2 2
HUZSOB
The Financial Markets
Financial markets are a system comprised of individuals and institutions, instruments, and procedures that bring together borrowers and savers, no matter the location.
Financial asset markets deal with stocks, bonds, mortgages, and other claims on real assets with respect to the distribution of future cash flows.
Besley Ch. 2 3
HUZSOB
The Financial Markets
Types of Markets:Debt Markets – trade loansEquity Markets – trade stockMoney Markets – trade debt with maturity less than 1
yearCapital Markets – trade long-term debt and stockMortgage Markets – trade residential, commercial,
and industrial real estate loansConsumer Credit Markets – trade car, education,
appliances and personal loans
Besley Ch. 2 4
HUZSOB
The Financial Markets
Types of Markets:Primary Markets – markets in which corporations and
governments raise funds by issuing new securitiesSecondary Markets – markets in which securities and
other financial assets are traded among investors after they have been issued by corporations and public agencies
Spot Markets – markets were financial assets are bought or sold on the spot
Futures Markets – markets were financial assets are bought or sold for delivery at some future date
Besley Ch. 2 5
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Financial Institutions
Three Primary Ways Capital Is Transferred Between Savers and Borrowers:
Direct Transfer Investment Bank Financial Intermediary (ie. bank; mutual fund)
Besley Ch. 2 6
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Forms of Capital TransferDirect Transfer
Business Savers
Securities (Stocks/Bonds)
Cash
Investment Bank
Investment Bank
Business SaversSecurities
Cash
Securities
Cash
Financial Intermediary
Financial Intermediary
Business Savers
Business’s Securities
Cash Cash
Intermediary’s Securities
Besley Ch. 2 7
HUZSOB
Investment Bank
Investment Bank: An organization that underwrites and distributes new issues of securities.
Investment Banks:Help corporations design securities with features that are
currently being demanded by investorsBuy these securities from the corporationResell these securities to investors.
Although the securities are sold twice, this transfer is considered on primary market transaction.
Besley Ch. 2 8
HUZSOB
Financial Intermediaries
Financial Intermediaries: Firms that facilitate the transfer of funds by creating new financial products.
Major Classes of Financial Intermediaries:Commercial BanksSavings and Loans (S&Ls)Credit UnionsPension FundsLife Insurance CompaniesMutual Funds
Besley Ch. 2 9
HUZSOB
The Stock Market
Two types of stock markets:Organized Exchanges
NYSEAMEX
Over-the-CounterNASDAQ
Besley Ch. 2 10
HUZSOB
Organized Security Exchanges
Formal organizations with physical locations where auction markets are conducted in designated (“listed”) securities.
Besley Ch. 2 11
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Over-the-Counter (OTC)
A large collection of brokers and dealers, connected electronically to trade securities not listed on the organized exchanges.
Characteristics of OTC markets:The relatively few market makers (dealers) that hold
inventories of OTC securitiesThe thousands of brokers that who act as agents in
bringing dealers together with investorsThe electronic network that links it all together.
Besley Ch. 2 12
HUZSOB
Over-the-Counter (OTC)
Bid Price: price at which dealer is willing to buy the the issue.
Asked Price: price at which dealer is willing to sell the issue.
Prices are continuously updated to reflect changes in supply and demand.
Bid/Ask Spread: represents dealers profit
Besley Ch. 2 13
HUZSOB
NASDAQ
National Association of Security Dealers:Self-regulated organization which licenses brokers and monitors trading activity.
NASDAQ-National Assoc. of Security Dealers Automated Quotation System
NASDAQ-AMEX-Philadelphia Stock Exchange merged in 1998
Besley Ch. 2 14
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The Cost of Money
Interest Rate – price paid to borrow money.Cost of Equity Capital – investor expectations
regarding dividends and capital gains.
Four factors affecting cost of money: Production Opportunities Time preferences for consumption Risk, and Inflation
Besley Ch. 2 15
HUZSOB
The Cost of Money
Interest rate paid to savers depends on:The rate of return producers expect to earn
on invested capitalSavers’ time preferences for current versus
future compensationThe riskiness of the loanThe expected future rate of inflation.
Besley Ch. 2 16
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Interest Rate Level
kB = 12
Dollars
Interest Rate, kB
Market B:High-Risk Securities
%
0
S1
D1
kA = 10
8
0 Dollars
%Interest Rate, kA
Market A: Low-Risk Securities
D1
D2
S1
Besley Ch. 2 17
HUZSOB
Note on Interest Rates
Short-term rates are responsive to current economic conditions.
Rise during economic boomsDrop during recessions
Besley Ch. 2 18
HUZSOB
The Determinants of Market Interest RatesNominal (or quoted) interest rate refers to the stated interest rate and not the real interest rate (which is adjusted for interest).
Quoted Interest Rate = k=k*+IP+DRP+LP+MRP
Where: k the quoted interest rate for a given security
k* the real risk free interest rateIP inflation premiumDRP default risk premiumLP liquidity premiumMRP maturity risk premium
Besley Ch. 2 19
HUZSOB
k*: Real Risk-Free Rate
Real Risk-Free Rate of Interest (k*)-the rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected.
Besley Ch. 2 20
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kRF: Nominal (Quoted) Risk-Free Rate
Nominal (Quoted) Risk-Free Rate (kRF)-the rate of interest on a security that is free of all risk; kRF is proxied by the T-Bill rate or the T-Bond rate.
kRF includes an inflation premium.
kRF = k*+IP
k= kRF +DRP+LP+MRP
Besley Ch. 2 21
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IP: Inflation Premium
Inflation Premium (IP)-a premium for expected inflation that investors add to the real risk-free rate of return.
IP = average inflation rate expected over the life of the security.
Besley Ch. 2 22
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DRP: Default Risk Premium
• Default Risk Premium (DRP)-the difference between the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability.
Rate DRPU.S. Treasury 5.40%AAA 6.40% 1.0%AA 6.70% 1.3%A 6.90% 1.5%
Besley Ch. 2 23
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LP: Liquidity Premium
Liquidity Premium (LP)-a premium added to the rate on a security if the security cannot be converted to cash on short notice and at close to the original cost.
Financial Assets are considered more liquid than real assets (ie. land and equipment).
Short-term financial assets are considered more liquid than long-term financial assets.
Besley Ch. 2 24
HUZSOB
MRP: Market Risk Premium
Market Risk Premium (MRP)-a premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk.
Interest Rate Risk-the risk of capital losses to which investors are exposed because of changing interest rates.
Reinvestment Rate Risk-the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.
Besley Ch. 2 25
HUZSOB
Premiums added to k* for Different Kinds of DebtIP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium
S-T treasury: only IP for S-T inflation L-T treasury: IP for L-T inflation, MRP S-T corporate: S-T IP, DRP, LP L-T corporate: IP, DRP, MRP, LP
Besley Ch. 2 26
HUZSOB
The Term Structure of Interest RatesTerm Structure of Interest Rates-the relationship
between yields (interest rates) and maturities of securities.
Understanding the relationship between ST and LT rates is important to corporate Treasurers since they must decide on ST versus LT funding/investing.
A graph of the term structure is called the yield curve.
Besley Ch. 2 27
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The Yield Curve
16
14
12
10
8
6
4
2
0
Interest Rate (%)
1 5 10 20
Term to Interest RateMaturity Mar 1980 Mar 19996 months 15.0% 4.6%1 year 14.0 4.95 years 13.5 5.210 years 12.8 5.520 years 12.5 5.9
Yield Curve for March 19992% inflation
Yield Curve for March 198012% inflation
Normal Yield Curve: Upward-sloping
Inverted Yield Curve: Downward-sloping
Besley Ch. 2 28
HUZSOB
Term Structure Theories
Three major theories to explain the shape of the yield curve:
• The Expectations Theory• The Liquidity Preference Theory• Market Segmentation Theory
Besley Ch. 2 29
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The Expectations Theory
Dictates that the shape of the yield curve is determined by investor’s expectations regarding inflation.
kRF,t = k* + IPt
Where: k* is the real risk-free rate
IPt is the average expected inflation period over t
yearsASSUMES: MRP = 0, DRP and LP for US Treasury Securities = 0.
Besley Ch. 2 30
HUZSOB
Calculating Interest Rates Under the Expectations TheoryStep 1: Find the Average Expected Inflation
Rate over the period (1 to N years)
IPn =
N INFLt
t=1 N
Besley Ch. 2 31
HUZSOB
Calculating Interest Rates Under the Expectations TheoryAssumptions:
k* = 3% Inflation Year 1 = 5% Inflation Year 2 = 6% Inflation Year 3+ = 8 % MRPt = 0.1% (t-1)
IP1 = 5%/ 1.0 = 5.00%IP10 = [ 5 + 6 + 8(8)] / 10 = 7.5%IP20 = [ 5 + 6 + 8(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).
Besley Ch. 2 32
HUZSOB
Calculating Interest Rates Under the Expectations TheoryStep 2: Find MRP based on this equation: MRPt =
0.1% (t - 1)
MRP1 = 0.1% x 0 = 0.0%
MRP10 = 0.1% x 9 = 0.9%
MRP20 = 0.1% x 19 = 1.9%
Besley Ch. 2 33
HUZSOB
Calculating Interest Rates Under the Expectations TheoryStep 3: Add the IPs and MRPs to k*:
kRFt = k* + IPt + MRPt
kRF = Quoted market interest rate on treasury securities.
1-Yr: kRF1 = 3% + 5.0% + 0.0% = 8.0%
10-Yr: kRF10 = 3% + 7.5% + 0.9% = 11.4%
20-Yr: kRF20 = 3% + 7.75% + 1.9% = 12.7
Besley Ch. 2 34
HUZSOB
Yield Curve
0
5
10
15
0 1 5 10 15 20
Inte
rest
Rate
(%
)
Years to Maturity
Yield Curve
Besley Ch. 2 35
HUZSOB
Liquidity Preference Theory
Dictates that the shape of the yield curve is determined by investor’s desire for liquidity.Everything else being equal, lenders prefer short-term
securities because they are less risky.Borrowers, will pay a higher interest rate on a loan to
extend the maturity (in order to mitigate the risk of having to repay the note under adverse conditions).
Therefore, short-term rates should be lower and the yield curve should be upward sloping.
Besley Ch. 2 36
HUZSOB
Market Segmentation Theory
Dictates that the shape of the yield curve is determined by market supply and demand.
Borrowers and lenders have preferred maturities.Slope of yield curve depends on supply and demand for
funds in both the long-term and short-term markets (curve could be flat, upward, or downward sloping).
The shape of the yield curve is affected by: Inflation expectationsLiquidity preferencesSupply and Demand conditions in long-term and short-term
markets
Besley Ch. 2 37
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Other Factors that Influence Interest Rate LevelsThe four most important factors are:
Federal Reserve Policy Controls the money supply
Federal Deficits When the Federal government expenditures exceed tax revenues;
the deficit is covered by:• Borrowing additional money in the market• Print more money
Larger federal deficit means higher interest ratesForeign Trade Balance
Larger trade deficit means higher interest rates Business Activity
Inflation Higher Rates/Recession Lower Rates S-T rates change more sharply than L-T rates
Besley Ch. 2 38
HUZSOB
Interest Rate Levels and Stock Prices
The higher the rate of interest, the lower a firm’s profits.
Interest rates affect the level of economic activity, and economic activity affects corporate profits.
Competition between stocks and bonds.
Besley Ch. 2 39
HUZSOB
The Federal Income Tax System
Individual Income Taxes
Corporate Income Taxes
Besley Ch. 2 40
HUZSOB
Individual Income Taxes
Individuals pay taxes on wages, salaries, investment income, and proprietorship/partnership profits.
Progressive tax – higher income = higher tax rate
Taxable Income - Gross income minus exemptions and allowable deductions as set forth in the tax code
Marginal Tax Rate - the tax on the last unit of income
Average Tax Rates - taxes paid divided by taxable income
Besley Ch. 2 41
HUZSOB
Individual Income Taxes
Your salary is $38,650
You received $2,100 in dividends
You are singleYour personal exemption is $2,750Your itemized deductions are $3,000
What is your Tax Liability?What is your Tax Liability?
Besley Ch. 2 42
HUZSOB
What is your Tax Liability?
• Step 1: Calculate your taxable income:
Salary $38,650
Dividends 2,100
Personal Exemption (2,750)
Deductions (3,000)
Taxable Income $35,000
Besley Ch. 2 43
HUZSOB
Taxable Income Tax on Base Rate*
1 - $25,750 0.00 15.0%
25,751 - 62,450 3,862.50 28.0%
62,451 - 130,250 14,138.50 31.0%
130,251 - 283,150 35,156.50 36.0%
Above 283,150 90,200.50 39.6%
*Plus this percentage on the amount over the bracket base.
Step 2: Consult the tax rate schedules: (Individual tax rates for 1999)
What is your Tax Liability?
Besley Ch. 2 44
HUZSOB
Tax LiabilityTax Liability =Base tax amount + tax rate(taxable income - $25,750)
Tax LiabilityTax Liability = $3,862.50 + 0.28($35,000 -$25,750) = $6,452.50.
Marginal Tax RateMarginal Tax Rate is the tax rate applied to the last unit of income = 28.0%
Average Tax RateAverage Tax Rate = Total tax liability / total taxable income= $6,452.50 / $35,000 = 18.4%
What is your Tax Liability?
Besley Ch. 2 45
HUZSOB
Individual Income Taxes
Taxes on Dividends and Interest IncomeDouble TaxationMunis are not subject to federal income tax
Interest Paid by IndividualsPersonal residence mortgages
Capital GainsStimulate liquidity for venture capitalIncrease reinvestment/decrease dividends
Besley Ch. 2 46
HUZSOB
Income $100,000
Taxable dividend income 3,000
Interest income 5,000
Taxable Income $108,000
Corporate Income Taxes
Besley Ch. 2 47
HUZSOB
Taxable Income Tax on Base Rate*
0 - 50,000 0 15%
50,001 - 75,000 7,500 25%
75,001 - 100,000 13,750 34%
100,001 - 335,000 22,250 39%
... ... ...
Over 18.3M 6.4M 35%
*Plus this percentage on the amount over the bracket base.
Corporate Tax Rates
Besley Ch. 2 48
HUZSOB
Tax LiabilityTax Liability = $22,250 + 0.39($108,000 - $100,000) = $ 25,370
Tax LiabilityTax Liability = Base tax amount +tax rate (taxable income - $100,000)
Corporate Tax Liability
Besley Ch. 2 49
HUZSOB
Corporate Tax Liability
Interest and Dividend Income Received by a CorporationOwnership ExclusionLess than 20% 70%20% but less than 80% 80%Greater than 80% 100%
Interest and Dividends Paid by a Corporation A firm needs $1 of pretax income to pay $1 of interest, but needs $1.54 of pretax income to pay $1 in dividends (assumes 35% tax bracket).
Corporate Loss Carryback and CarryoverLosses that can be carried back (2 years) and forward (20 years) to offset taxable income.
Besley Ch. 2 50
HUZSOB
Corporate Tax Codes Differ from Individual Tax Codes:• Interest and dividend income received• Interest and dividends paid by a corporation• Corporate capital gains• Corporate loss carryback and carryover• Accumulated earnings tax • Consolidated corporate tax returns• Taxation of small business S corporations• Depreciation
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