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

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Presentation on theme: "H U ZSOB Introduction to Managerial Finance The Financial Environment: Markets, Institutions, Interest Rates and Taxes Besley: Chapter 2."— Presentation transcript:

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

2 H U ZSOB Besley Ch. 22 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.

3 H U ZSOB Besley Ch. 23 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

4 H U ZSOB Besley Ch. 24 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

5 H U ZSOB Besley Ch. 25 Financial Institutions Three Primary Ways Capital Is Transferred Between Savers and Borrowers:  Direct Transfer  Investment Bank  Financial Intermediary (ie. bank; mutual fund)

6 H U ZSOB Besley Ch. 26 Forms of Capital Transfer Direct Transfer BusinessSavers Securities (Stocks/Bonds) Cash Investment Bank BusinessSavers Securities Cash Securities Cash Financial Intermediary BusinessSavers Business’s Securities Cash Intermediary’s Securities

7 H U ZSOB Besley Ch. 27 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.

8 H U ZSOB Besley Ch. 28 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

9 H U ZSOB Besley Ch. 29 The Stock Market Two types of stock markets:  Organized Exchanges  NYSE  AMEX  Over-the-Counter  NASDAQ

10 H U ZSOB Besley Ch. 210 Organized Security Exchanges Formal organizations with physical locations where auction markets are conducted in designated (“listed”) securities.

11 H U ZSOB Besley Ch. 211 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.

12 H U ZSOB Besley Ch. 212 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

13 H U ZSOB Besley Ch. 213 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

14 H U ZSOB Besley Ch. 214 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

15 H U ZSOB Besley Ch. 215 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.

16 H U ZSOB Besley Ch. 216 Interest Rate Level k B = 12 Dollars Interest Rate, k B Market B:High-Risk Securities % 0 S1S1 D1D1 k A = Dollars % Interest Rate, k A Market A: Low-Risk Securities D1D1 D2D2 S1S1

17 H U ZSOB Besley Ch. 217 Note on Interest Rates Short-term rates are responsive to current economic conditions.  Rise during economic booms  Drop during recessions

18 H U ZSOB Besley Ch. 218 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:kthe quoted interest rate for a given security k*the real risk free interest rate IPinflation premium DRPdefault risk premium LPliquidity premium MRPmaturity risk premium

19 H U ZSOB Besley Ch. 219 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.

20 H U ZSOB Besley Ch. 220 k RF : Nominal (Quoted) Risk-Free Rate Nominal (Quoted) Risk-Free Rate (k RF )-the rate of interest on a security that is free of all risk; k RF is proxied by the T-Bill rate or the T-Bond rate. k RF includes an inflation premium. k RF = k*+IP k= k RF +DRP+LP+MRP

21 H U ZSOB Besley Ch. 221 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.

22 H U ZSOB Besley Ch. 222 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.

23 H U ZSOB Besley Ch. 223 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.

24 H U ZSOB Besley Ch. 224 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.

25 H U ZSOB Besley Ch. 225 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

26 H U ZSOB Besley Ch. 226 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.

27 H U ZSOB Besley Ch. 227 The Yield Curve Interest Rate (%) Term to Interest Rate Maturity Mar 1980Mar months 15.0% 4.6% 1 year years years years Yield Curve for March % inflation Yield Curve for March % inflation Normal Yield Curve: Upward-sloping Inverted Yield Curve: Downward-sloping

28 H U ZSOB Besley Ch. 228 Term Structure Theories Three major theories to explain the shape of the yield curve: The Expectations Theory The Liquidity Preference Theory Market Segmentation Theory

29 H U ZSOB Besley Ch. 229 The Expectations Theory Dictates that the shape of the yield curve is determined by investor’s expectations regarding inflation. k RF,t = k* + IP t Where: k* is the real risk-free rate IP t is the average expected inflation period over t years ASSUMES: MRP = 0, DRP and LP for US Treasury Securities = 0.

30 H U ZSOB Besley Ch. 230 Calculating Interest Rates Under the Expectations Theory Step 1: Find the Average Expected Inflation Rate over the period (1 to N years) IP n = N  INFL t t=1 N

31 H U ZSOB Besley Ch. 231 Calculating Interest Rates Under the Expectations Theory Assumptions:  k* = 3%  Inflation Year 1 = 5%  Inflation Year 2 = 6%  Inflation Year 3+ = 8 %  MRP t = 0.1% (t-1) IP 1 = 5%/ 1.0 = 5.00% IP 10 = [ (8)] / 10 = 7.5% IP 20 = [ (18)] / 20 = 7.75% Must earn these IPs to break even vs. inflation; these IPs would permit you to earn k* (before taxes).

32 H U ZSOB Besley Ch. 232 Calculating Interest Rates Under the Expectations Theory Step 2: Find MRP based on this equation: MRP t = 0.1% (t - 1) MRP 1 = 0.1% x 0= 0.0% MRP 10 = 0.1% x 9= 0.9% MRP 20 = 0.1% x 19= 1.9%

33 H U ZSOB Besley Ch. 233 Calculating Interest Rates Under the Expectations Theory Step 3: Add the IPs and MRPs to k*: k RFt = k* + IP t + MRP t k RF = Quoted market interest rate on treasury securities. 1-Yr: k RF1 = 3% + 5.0% + 0.0% = 8.0% 10-Yr: k RF10 = 3% + 7.5% + 0.9% = 11.4% 20-Yr: k RF20 = 3% % + 1.9% = 12.7

34 H U ZSOB Besley Ch. 234 Yield Curve Interest Rate (%) Years to Maturity Yield Curve

35 H U ZSOB Besley Ch. 235 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.

36 H U ZSOB Besley Ch. 236 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

37 H U ZSOB Besley Ch. 237 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  Higher Rates/Recession  Lower Rates  S-T rates change more sharply than L-T rates

38 H U ZSOB Besley Ch. 238 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.

39 H U ZSOB Besley Ch. 239 The Federal Income Tax System  Individual Income Taxes  Corporate Income Taxes

40 H U ZSOB Besley Ch. 240 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

41 H U ZSOB Besley Ch. 241 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?

42 H U ZSOB Besley Ch. 242 What is your Tax Liability? Step 1: Calculate your taxable income: Salary$38,650 Dividends2,100 Personal Exemption (2,750) Deductions (3,000) Taxable Income $35,000

43 H U ZSOB Besley Ch. 243 Step 2: Consult the tax rate schedules: (Individual tax rates for 1999) What is your Tax Liability?

44 H U ZSOB Besley Ch. 244 Tax Liability =Base tax amount + tax rate(taxable income - $25,750) Tax Liability Tax Liability = $3, ($35,000 -$25,750) = $6, Marginal Tax Rate Marginal Tax Rate is the tax rate applied to the last unit of income = 28.0% Average Tax Rate Average Tax Rate = Total tax liability / total taxable income = $6, / $35,000 = 18.4% What is your Tax Liability?

45 H U ZSOB Besley Ch. 245 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

46 H U ZSOB Besley Ch. 246 Corporate Income Taxes

47 H U ZSOB Besley Ch. 247 Corporate Tax Rates

48 H U ZSOB Besley Ch. 248 Tax Liability = $22, ($108,000 - $100,000) = $ 25,370 Tax Liability = Base tax amount +tax rate (taxable income - $100,000) Corporate Tax Liability

49 H U ZSOB Besley Ch. 249 Corporate Tax Liability Interest and Dividend Income Received by a Corporation OwnershipExclusion 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.

50 H U ZSOB Besley Ch. 250 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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