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Introduction to Managerial Finance The Financial Environment: Markets, Institutions, Interest Rates and Taxes Besley : Chapter 2 The Financial Markets

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Introduction to managerial finance l.jpg

Introduction to Managerial Finance

The Financial Environment: Markets, Institutions, Interest Rates and Taxes

Besley: Chapter 2


The financial markets l.jpg
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


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The Financial Markets

Types of Markets:

  • Debt Markets – trade loans

  • Equity Markets – trade stock

  • Money Markets – trade debt with maturity less than 1 year

  • Capital Markets – trade long-term debt and stock

  • Mortgage Markets – trade residential, commercial, and industrial real estate loans

  • Consumer Credit Markets – trade car, education, appliances and personal loans

Besley Ch. 2


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The Financial Markets

Types of Markets:

  • Primary Markets – markets in which corporations and governments raise funds by issuing new securities

  • Secondary 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


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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


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Direct Transfer

Securities (Stocks/Bonds)

Business

Savers

Cash

Investment Bank

Securities

Securities

Business

Savers

Investment Bank

Cash

Cash

Financial Intermediary

Business’s Securities

Intermediary’s Securities

Business

Savers

Financial Intermediary

Cash

Cash

Forms of Capital Transfer

Besley Ch. 2


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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 investors

  • Buy these securities from the corporation

  • Resell these securities to investors.

    Although the securities are sold twice, this transfer is considered on primary market transaction.

Besley Ch. 2


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Financial Intermediaries

Financial Intermediaries: Firms that facilitate the transfer of funds by creating new financial products.

Major Classes of Financial Intermediaries:

  • Commercial Banks

  • Savings and Loans (S&Ls)

  • Credit Unions

  • Pension Funds

  • Life Insurance Companies

  • Mutual Funds

Besley Ch. 2


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The Stock Market

Two types of stock markets:

  • Organized Exchanges

    • NYSE

    • AMEX

  • Over-the-Counter

    • NASDAQ

Besley Ch. 2


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Organized Security Exchanges

Formal organizations with physical locations where auction markets are conducted in designated (“listed”) securities.

Besley Ch. 2


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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 securities

  • The thousands of brokers that who act as agents in bringing dealers together with investors

  • The electronic network that links it all together.

Besley Ch. 2


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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


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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


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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


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The Cost of Money

Interest rate paid to savers depends on:

  • The rate of return producers expect to earn on invested capital

  • Savers’ time preferences for current versus future compensation

  • The riskiness of the loan

  • The expected future rate of inflation.

Besley Ch. 2


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Interest Rate Level

Market A: Low-Risk Securities

Market B:High-Risk Securities

Interest Rate, kA

Interest Rate, kB

%

S1

%

S1

kB = 12

kA = 10

8

D1

D1

D2

0

0

Dollars

Dollars

Besley Ch. 2


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Note on Interest Rates

Short-term rates are responsive to current economic conditions.

  • Rise during economic booms

  • Drop during recessions

Besley Ch. 2


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The Determinants of Market Interest Rates

Nominal (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 rate

    • IP inflation premium

    • DRP default risk premium

    • LP liquidity premium

    • MRP maturity risk premium

Besley Ch. 2


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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


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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.

kRFincludes an inflation premium.

kRF = k*+IP

k= kRF +DRP+LP+MRP

Besley Ch. 2


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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


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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.

Besley Ch. 2


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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


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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


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Premiums added to k* for Different Kinds of Debt

IP = Inflation premium

DRP = Default risk premium

LP = Liquidity premium

MRP = 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


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The Term Structure of Interest Rates

Term 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


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Inverted Yield Curve: Downward-sloping

Normal Yield Curve: Upward-sloping

The Yield Curve

Term to Interest RateMaturity Mar 1980 Mar 19996 months 15.0%4.6%1 year 14.04.95 years 13.55.210 years 12.85.520 years 12.55.9

Interest Rate (%)

16

14

12

10

8

6

4

2

0

Yield Curve for March 1980

12% inflation

Yield Curve for March 1999

2% inflation

1 5 10 20

Besley Ch. 2


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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


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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

IPtis the average expected inflation period over t years

ASSUMES: MRP = 0, DRP and LP for US Treasury Securities = 0.

Besley Ch. 2


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N

S INFLt

t=1

N

IPn =

Calculating Interest Rates Under the Expectations Theory

Step 1: Find the Average Expected Inflation Rate over the period (1 to N years)

Besley Ch. 2


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Calculating Interest Rates Under the Expectations Theory

Assumptions:

  • 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


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Calculating Interest Rates Under the Expectations Theory

Step 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


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Calculating Interest Rates Under the Expectations Theory

Step 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


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Yield Curve

Yield Curve

Interest Rate (%)

Years to Maturity

Besley Ch. 2


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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


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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 expectations

    • Liquidity preferences

    • Supply and Demand conditions in long-term and short-term markets

Besley Ch. 2


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Other Factors that Influence Interest Rate Levels

The 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 rates

  • Foreign Trade Balance

    • Larger trade deficit means higher interest rates

  • Business Activity

    • Inflation à Higher Rates/Recession à Lower Rates

    • S-T rates change more sharply than L-T rates

Besley Ch. 2


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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


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The Federal Income Tax System

  • Individual Income Taxes

  • Corporate Income Taxes

Besley Ch. 2


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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


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Individual Income Taxes

Your salary is $38,650

You received $2,100 in dividends

You are single

  • Your personal exemption is $2,750

  • Your itemized deductions are $3,000

  • What is your Tax Liability?

Besley Ch. 2


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Deductions (3,000)

What is your Tax Liability?

  • Step 1: Calculate your taxable income:

Salary $38,650

Dividends 2,100

Personal Exemption (2,750)

Taxable Income $35,000

Besley Ch. 2


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What is your Tax Liability?

Step 2: Consult the tax rate schedules: (Individual tax rates for 1999)

Besley Ch. 2


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What is your Tax Liability?

Tax Liability

=Base tax amount + tax rate(taxable income - $25,750)

Tax Liability = $3,862.50 + 0.28($35,000 -$25,750) = $6,452.50.

Marginal Tax Rate is the tax rate applied to the last unit of income = 28.0%

Average Tax Rate =

Total tax liability / total taxable income

= $6,452.50 / $35,000 = 18.4%

Besley Ch. 2


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Individual Income Taxes

Taxes on Dividends and Interest Income

  • Double Taxation

  • Munis are not subject to federal income tax

    Interest Paid by Individuals

  • Personal residence mortgages

    Capital Gains

  • Stimulate liquidity for venture capital

  • Increase reinvestment/decrease dividends

Besley Ch. 2



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Corporate Tax Rates

Besley Ch. 2


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Corporate Tax Liability

Tax Liability

= Base tax amount +tax rate (taxable income - $100,000)

Tax Liability

= $22,250 + 0.39($108,000 - $100,000)

=$ 25,370

Besley Ch. 2


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Corporate Tax Liability

Interest and Dividend Income Received by a Corporation

Ownership Exclusion

Less 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 Carryover

Losses that can be carried back (2 years) and forward (20 years) to offset taxable income.

Besley Ch. 2


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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

Besley Ch. 2