You are on page 1of 8

eFINANCIAL MANAGEMENT  The corporation exists legally separate and apart from its

First Trimester 2016 owners.


By Alfredo M. Ofrecio III  Ownership itself is evidenced by shares of stock, with each
stockholder owning that proportion of the enterprise
represented by his or her shares in relation to the total
Course Overview: number of shares outstanding.
1. Introduction to Financial Management  Unlimited life. Because the corporation exists apart from its
2. Valuation owners, its life is not limited by the lives of the owners (unlike
3. Financial Analysis and Planning proprietorships and partnerships). The corporation can
4. Capital Management and Investment continue even though individual owners may die or sell their
5. Cost of Capital, Capital Structure and Dividend stock.
Policy  Easy transfer of ownership.
6. Zero Base Budget Setup
Disadvantage:
 Corporate profits are subject to double taxation.
PART 2. INTRODUCTION TO FINANCIAL MANAGEMENT The company pays tax on the income it earns, and
the stockholder is also taxed when he or she
“The Business, Tax, and Financial Environment” receives income in the form of a cash dividend.
 The length of time to incorporate and the red tape
Chapter Overview: involved, as well as the incorporation fee that must
A. The Business Environment be paid to the state in which the firm is
B. The Tax Environment incorporated.
C. The Financial Environment  Thus, it is more difficult to establish.

5. LIMITED LIABILITY COMPANIES (LLCs)


A. THE BUSINESS ENVIRONMENT  A business form that provides its owners (called “members”)
with corporate-style limited personal liability and the federal-
Four Basic Forms of Business Organizations in the US: tax treatment of a partnership.
1. Sole proprietorships  Well suited for small and medium sized enterprises.
2. Partnerships  It has fewer restrictions and greater flexibility.
3. Corporations  Limited liability companies generally possess no more than
4. Limited Liability Companies two of the following four (desirable) standard corporate
characteristics:
1. SOLE PROPRIETORSHIPS  Limited liability
 Oldest form of business organization  Centralized management
 A single person owns the business, holds title to all its assets,  Unlimited life
and is personally responsible for all of its debts.  The ability to transfer ownership interest without
 It pays no separate income taxes. The owner merely adds any prior consent of the other owners.
profits or subtracts any losses from the business when
determining personal taxable income. Drawbacks:
 Widely used in service industries.  Generally lacks the corporate feature of unlimited
 Can be established with few complications and little expense. life.
 Complete transfer of an ownership interest is
Shortcomings: usually subject to the approval of a least a majority
 The proprietor has unlimited liability. of the other LLC members.
 Difficulty in raising capital.
 Certain tax disadvantages.
 Transfer of ownership more difficult than does the
B. THE TAX ENVIRONMENT
corporate form.

Through their taxing power, federal, state, and local governments have
2. PARTNERSHIPS
a profound influence on the behavior of businesses and their owners.
 A business form in which two or more individuals act as
owners.
CORPORATE INCOME TAXES
 Pays no income taxes.
A corporation’s taxable income is found by deducting all allowable
 Relative to a proprietorship, a greater amount of capital can
expenses, including depreciation and interest, from revenues. This
often be raised
taxable income is then subjected to certain tax structure.
 In a general partnership all partners have unlimited liability;
they are jointly liable for the obligations of the partnership.
 Depreciation - the systematic allocation of the cost of a capital
 Can be easily dissolved.
asset over a period of time for financial reporting purposes, tax
 In a limited partnership, limited partners contribute capital
purposes, or both. It is treated as expense items. Everything else
and have liability confined to that amount of capital; they
being equal, the greater the depreciation charges, the lower the
cannot lose more than they put in. There must, however, be
tax.
at least one general partner in the partnership, whose liability
is unlimited.
 Procedure for depreciating capital assets:
a. Straight-line depreciation method - A method of depreciation
3. CORPORATIONS
that allocates expenses evenly over the depreciable life of the
 A business form legally separate from its owners. Its
asset.
distinguishing features include limited liability, easy transfer
b. Accelerated depreciation – Methods of depreciation that
of ownership, unlimited life, and an ability to raise large sums
write off the cost of a capital asset faster than under straight-
of capital.
line depreciation.
 An artificial entity created by law.
 It can own assets and incur liabilities.
 The Tax Reform Act of 1986 (US) allows companies to use a
particular type of accelerated depreciation for tax purposes; it is

Page 1 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


known as the Modified Accelerated Cost Recovery System  Interest Expense versus Dividends Paid. Interest paid on
(MACRS, pronounced “makers”). outstanding corporate debt is treated as an expense and is tax
 Under MACRS, machinery, equipment, and real estate deductible. However, dividends paid to preferred or common
are assigned to one of eight classes for purposes of stockholders are not tax deductible.
determining a prescribed life, called a cost recovery  Thus, for a profitable, tax-paying company, the use of debt
period, and a depreciation method. The property class in (e.g., bonds) in its financing mix results in a significant tax
which an asset falls determines its cost recovery period advantage relative to the use of preferred or common stock.
or prescribed life for tax purposes – a life that may differ  Given a marginal tax rate of 35 percent, a firm that pays out
from the asset’s useful or economic life. $1 in interest lowers its tax bill by 35 cents because of its
ability to deduct the $1 of interest from taxable income. The
after-tax cost of $1 of interest for this firm is really only 65
cents – $1 × (1 − tax rate). On the other hand, the after-tax
cost of $1 of dividends paid by the firm is still $1 – there is no
tax advantage here.

 Dividend Income. A corporation may own stock in another


company. If it receives a cash dividend on this stock, normally 70
percent of the dividend is tax exempt.

 Carryback and Carryforward. If a corporation sustains a net


operating loss, this loss may generally be carried back 2 years and
forward up to 20 years to offset taxable income in those years.

(For tax purposes, expected salvage value does not affect depreciation  Capital Gains and Losses. When a capital asset (as defined by the
charges.) Internal Revenue Service) is sold, a capital gain or loss is generally
incurred. Capital gains are taxed at the ordinary income tax rates
 Declining-balance depreciation method. Calls for an annual for corporations, or a maximum of 35 percent. Capital losses are
charge that is a “fixed percentage” of the asset’s net book value deductible only against capital gains.
(acquisition cost minus accumulated depreciation) at the
beginning of the year to which the depreciation charge applies.
PERSONAL INCOME TAXES
m(1/n)NBV The subject of personal taxes is extremely complex, but our main
concern here is with the personal taxes of individuals who own
 where m is the multiple, n is the depreciable life of businesses – proprietors, partners, members (of LLCs), and
the asset and NBV is the asset’s net book value. shareholders.

 Modified Accelerated Cost Recovery System (MACRS)  Interest, Dividends, and Capital Gains. Taxable interest is subject
 For the 3-, 5-, 7-, and 10-year property classes, the to the ordinary income tax rates. The current maximum dividend
double declining balance (also called 200% and capital gains tax rates for most (but not all) cash dividends
declining balance) depreciation method is used. received and realized net capital gains are both 15 percent for
 This method then switches to straight-line qualifying taxpayers.
depreciation for the remaining undepreciated book
value in the first year that the straight-line method
yields an equal or greater deduction than the C. THE FINANCIAL ENVIRONMENT
declining-balance method.
 Assets in the 15- and 20-year classes are In varying degrees, all businesses operate within the financial system,
depreciated using the 150 percent declining which consists of a number of institutions and markets serving business
balance method, again switching to straight-line at firms, individuals, and governments.
the optimal time.
 The straight-line method must be used for all real Financial Markets. All institutions and procedures for bringing buyers
estate. and sellers of financial instruments together.
 Normally, the half-year convention must be applied  Most firms use financial markets to help finance their
to all declining-balance methods. investment in assets.
This calls for a half year of depreciation in  The market price of a company’s securities is the test of
the year an asset is acquired, regardless of the date whether the company is a success or a failure
of purchase. There is also a half year of depreciation
in the year an asset is sold or retired from service. If THE PURPOSE OF FINANCIAL MARKETS
property is held for longer than its recovery period, Financial assets exist in an economy because the savings of various
a half year of depreciation is allowed for the year individuals, corporations, and governments during a period of time
following the end of the recovery period. differ from their investment in real assets.

If savings equaled investment in real assets for all economic units in an


economy over all periods of time, there would be no external financing,
no financial assets, and no money or capital markets.

A financial asset is created only when the investment of an economic


unit in real assets exceeds its savings, and it finances this excess by
borrowing or issuing stock. Of course, another economic unit must be
willing to lend. This interaction of borrowers with lenders determines
interest rates. In the economy as a whole, savings-surplus units (those
whose savings exceed their investment in real assets) provide funds to
savings-deficit units (those whose investments in real assets exceed
their savings). This exchange of funds is evidenced by investment

Page 2 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


instruments, or securities, representing financial assets to the holders and letting the intermediaries do the lending to the ultimate investors.
and financial liabilities to the issuers. We usually think of financial intermediation making the markets more
efficient by lowering the cost and/or inconvenience to consumers of
The purpose of financial markets in an economy is to allocate savings financial services.
efficiently to ultimate users. If those economic units that saved were the
same as those that engaged in capital formation, an economy could  Deposit Institutions - Commercial banks are the most
prosper without financial markets. In modern economies, however, important source of funds for business firms in the aggregate.
most nonfinancial corporations use more than their total savings for Banks acquire demand (checking) and time (savings) deposits
investing in real assets. Most households, on the other hand, have total from individuals, companies, and governments and, in turn,
savings in excess of total investment. Efficiency entails bringing the make loans and investments. Besides performing a banking
ultimate investor in real assets and the ultimate saver together at the function, commercial banks affect business firms through
least possible cost and inconvenience. their trust departments, which invest in corporate bonds and
stocks. They also make mortgage loans available to
companies and manage pension funds.

Other deposit institutions include savings and loan


associations, mutual savings banks, and credit unions. These
institutions are primarily involved with individuals, acquiring
their savings and making home and consumer loans.

 Insurance Companies - These are in the business of collecting


periodic payments from those they insure in exchange for
providing payouts should events, usually adverse, occur. With
the funds received in premium payments, insurance
companies build reserves. These reserves and a portion of the
insurance companies’ capital are invested in financial assets.
a. Property and casualty companies - insure
against fires, thefts, car accidents, and similar
unpleasantness. Because these companies pay
taxes at the full corporate income tax rate,
they invest heavily in municipal bonds, which
offer tax-exempt interest income. To a lesser
FINANCIAL MARKETS extent they also invest in corporate stocks and
They are mechanisms for channeling savings to the ultimate investors bonds.
in real assets. b. Life insurance companies - insure against the
loss of life. Because the mortality of a large
The secondary market, financial intermediaries, and financial brokers group of individuals is highly predictable, these
are the key institutions that enhance funds flows. companies are able to invest in long-term
securities. Also, the income of these
TWO CLASSES OF FINANCIAL MARKETS institutions is partially exempt from taxes
1. Money Market – The market for short-term (less than one owing to the buildup of reserves over time.
year original maturity) government and corporate debt Life insurance companies invest heavily in
securities. It also includes government securities originally corporate bonds.
issued with maturities of more than one year but that now
have a year or less until maturity.  Other Financial Intermediaries
2. Capital Market – The market for relatively long-term (greater a. Pension funds and other retirement funds –
than one year original maturity) financial instruments (e.g., established to provide income to individuals
bonds and stocks). when they retire. Because of the long-term
nature of their liabilities, pension funds are
Within money and capital markets there exist both primary and able to invest in longer-term securities. As a
secondary markets. result, they invest heavily in corporate stocks
1. Primary Market - A market where new securities are bought and bonds. In fact, pension funds are the
and sold for the first time (a “new issues” market). largest single institutional investors in
2. Secondary Market - A market for existing (used) securities corporate stocks.
rather than new issues. Transactions in these already existing b. Mutual investment funds - also invest heavily
securities do not provide additional funds to finance capital in corporate stocks and bonds. These funds
investment. accept monies contributed by individuals and
invest them in specific types of financial assets.
Thus, the existence of a strong secondary market enhances The mutual fund is connected with a
the efficiency of the primary market. management company, to which the fund pays
a fee (frequently 0.5 percent of total assets per
FINANCIAL INTERMEDIARIES annum) for professional investment
Financial institutions that accept money from savers and use those management.
funds to make loans and other financial investments in their own name. c. Finance Companies - make consumer
They include commercial banks, savings institutions, insurance installment loans, personal loans, and secured
companies, pension funds, finance companies, and mutual funds. loans to business enterprises. These
companies raise capital through stock issues as
These intermediaries come between ultimate borrowers and lenders by well as through borrowings, some of which are
transforming direct claims into indirect claims. Financial intermediaries long term but most of which come from
purchase direct (or primary) securities and, in turn, issue their own commercial banks. In turn, the finance
indirect (or secondary) securities to the public. company makes loans.

Financial intermediation is the process of savers depositing funds with


financial intermediaries (rather than directly buying stocks and bonds)
Page 3 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com
FINANCIAL BROKERS It is important to recognize that the process by which savings are
allocated in an economy occurs not only on the basis of expected return
When brokers bring together parties who need funds with those who but on the basis of risk as well.
have savings, they are not performing a direct lending function but
rather are acting as matchmakers, or middlemen.

 Investment Banker - A financial institution that underwrites


(purchases at a fixed price on a fixed date) new securities for
resale.

Investment bankers are middlemen involved in the sale of


corporate stocks and bonds When a company decides to raise
funds, an investment banker will often buy the issue (at wholesale)
and then turn around and sell it to investors (at retail). Because
investment bankers are continually in the business of matching
users of funds with suppliers, they can sell issues more efficiently
than can the issuing companies. For this service investment  Default Risk - the danger that the borrower may not meet
bankers receive fees in the form of the difference between the payments due on principal or interest. Investors demand a
amounts received from the sale of the securities to the public and risk premium (or extra expected return) to invest in securities
the amounts paid to the companies. that are not default free.

 Mortgage Banker - A financial institution that originates (buys) For the typical investor, default risk is not judged directly but
mortgages primarily for resale. rather in terms of quality ratings assigned by the principal
rating agencies, Moody’s Investors Service and Standard &
Mortgage bankers are involved in acquiring and placing mortgages. Poor’s.
These mortgages come either directly from individuals and
businesses or, more typically, through builders and real estate
agents. In turn, the mortgage banker locates institutional and
other investors for the mortgages. Although mortgage bankers do
not typically hold mortgages in their own portfolios for very long,
they usually service mortgages for the ultimate investors. This
involves receiving payments and following through on
delinquencies. For this service they receive fees.

THE SECONDARY MARKET


Purchases and sales of existing financial assets occur in the secondary
market. Transactions in this market do not increase the total amount of
financial assets outstanding, but the presence of a viable secondary
market increases the liquidity of financial assets and therefore enhances
the primary or direct market for securities.  Marketability (or Liquidity) - The ability to sell a significant
volume of securities in a short period of time in the secondary
In this regard, organized exchanges, such as the New York Stock market without significant price concession. It relates to the
Exchange, the American Stock Exchange, and the New York Bond owner’s ability to convert it into cash.
Exchange, provide a means by which buy and sell orders can be
efficiently matched. In this matching, the forces of supply and demand Two dimensions:
determine price. a. The price realized
b. The amount of time required to sell the asset
In addition, the over-the-counter (OTC) market serves as part of the
secondary market for stocks and bonds not listed on an exchange as The more marketable the security, the greater the ability to
well as for certain listed securities. It is composed of brokers and dealers execute a large transaction near the quoted price. In general,
who stand ready to buy and sell securities at quoted prices. Most the lower the marketability of a security, the greater the yield
corporate bonds, and a growing number of stocks, are traded OTC as necessary to attract investors. Thus the yield differential
opposed to being traded on an organized exchange. The OTC market between different securities of the same maturity is caused
has become highly mechanized, with market participants linked not by differences in default risk alone, but also by differences
together by a telecommunications network. They do not come together in marketability.
in a single place as they would on an organized exchange. The National
Association of Securities Dealers Automated Quotation Service  Maturity - The life of a security; the amount of time before
(NASDAQ, pronounced “nas-dac”) maintains this network, and price the principal amount of a security becomes due.
quotations are instantaneous. Whereas once it was considered a matter
of prestige, as well as a necessity in many cases, for a company to list its Securities with about the same default risk, having similar
shares on a major exchange, the electronic age has changed that. Many marketability, and not faced with different tax implications
companies now prefer to have their shares traded OTC, despite the fact can still trade at different yields. Why? “Time” is the answer.
that they qualify for listing, because they feel that they get as good or The maturity of a security can often have a powerful effect on
sometimes better execution of buy and sell orders. expected return, or yield. The relationship between yield and
maturity for securities differing only in the length of time (or
ALLOCATION OF FUNDS AND INTEREST RATES term) to maturity is called the term structure of interest
The allocation of funds in an economy occurs primarily on the basis of rates.
price, expressed in terms of expected return. Expected return
constitutes the primary mechanism by which supply and demand are The graphical representation of this relationship at a moment
brought into balance for a particular financial instrument across in time is called a yield curve.
financial markets. If risk is held constant, economic units willing to pay
the highest expected return are the ones entitled to the use of funds.  Taxability - The most important tax, and the only one that we
will consider here, is income tax. The interest income on all
but one category of securities is taxable to taxable investors.

Page 4 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


Interest income from state and local government securities is resources of the business to the owners personally. Fringe benefits are
tax exempt. not deductible as an expense. Also, both forms of organization lack the
corporate feature of “unlimited life”. With the partnership there are
 Option Features - Another consideration is whether a security problems of control and management. The ownership is not liquid when
contains any option features, such as a conversion privilege or it comes to planning for individual estates. Decision making can be
warrants, which upon exercise allow the investor to obtain cumbersome. An LLC generally lacks the feature of “unlimited life”, and
common stock. Other options include the call feature, which complete transfer of an ownership interest is usually subject to the
enables a company to prepay its debt, and a sinking-fund approval of at least a majority of the other LLC members.
provision, which allows a company to retire bonds periodically
with cash payments or by buying bonds in the secondary 4. What kind of corporation benefits from the graduated income
market. tax?

 Inflation - inflation expectations have a substantial influence The chief beneficiaries are smaller companies where the first $75,000 in
on interest rates overall. It is generally agreed that the taxable income is a large portion, if not all, of their total taxable income.
nominal (observed) rate of interest on a security embodies a
premium for inflation. The higher the expected inflation, the 5. In general, what are the principles on which the Modified
higher the nominal yield on the security; and the lower the Accelerated Cost Recovery System (MACRS) is based?
expected inflation, the lower the nominal yield.
Accelerated depreciation is used up to the point it is advantageous to
Many years ago Irving Fisher expressed the nominal rate of switch to straight line depreciation. A one-half year convention is
interest on a bond as the sum of the real rate of interest (i.e., followed in the first year, which reduces the cost recovery in that year
the interest rate in the absence of price level changes) and the from what would otherwise be the case. Additionally, a one-half year
rate of price change expected to occur over the life of the convention is followed in the year following the asset class. This pushes
instrument. out the depreciation schedule, which is disadvantageous from a present
value standpoint. The double declining balance method is used for the
This states merely that lenders require a nominal rate of first four asset classes, 3, 5, 7 and 10 years. The asset category
interest high enough for them to earn the real rate of interest determines the project’s depreciable life.
after being compensated for the expected decrease in the
buying power of money caused by inflation. 6. Interest on Treasury securities is not taxable at the state level,
whereas interest on municipal securities is not taxable at the
 Behavior of Yields on Corporate Securities - Differences in federal level. What is the reason for this feature?
default risk, marketability, maturity, taxability, and option
features affect the yield of one security relative to another at The immunity from each other’s taxing power dates back to the early
a point in time. In addition, the security yields themselves part of the 19th century. It used to apply to salaries of government
(and hence the cost of funds to business firms) will vary over employees as well. The exemption is historical, and it is hard to
time. Fluctuations in supply and demand pressures in financial rationalize from the standpoint of economic/taxing efficiency.
markets, as well as changing inflation expectations, help
explain this variability in yields. 7. Are individual tax rates progressive or regressive in the sense of
increasing or decreasing with income levels?
QUESTIONS
Personal tax rates are progressive up to a point, then become
regressive.
1. What is the principal advantage of the corporate form of business
organization? Discuss the importance of this advantage to the 8. If capital gains were to be taxed at a lower rate than ordinary
owner of a small family restaurant. Discuss the importance of this income, as has been the case in the past, what types of
advantage to a wealthy entrepreneur who owns several investments would be favored?
businesses.
With the differential taxation of ordinary income and capital gains,
The principal advantage of the corporate form of business organization securities with a higher likelihood of capital gains are tax advantaged.
is that the corporation has limited liability. The owner of a small family These include low dividend common stocks, common stocks in general,
restaurant might be required to personally guarantee corporate discount bonds, real estate, and other investments of this sort.
borrowings or purchases anyway, so much of this advantage might be
eliminated. The wealthy individual has more at stake and unlimited 9. The method of depreciation does not alter the total amount
liability might cause, one failing business to bring down the other deducted from income during the life of an asset. What does it
healthy businesses. alter and why is that important?

2. How does being a limited partner in a business enterprise differ Depreciation changes the timing of tax payments. The longer these
from being a stockholder, assuming the same percentage of payments can be delayed, the better off the business is.
ownership?
10. If the owners of a new corporation are very few in number, does
The liability is limited to the amount of the investment in both the becoming an S Corporation make sense for tax purposes? Explain.
limited partnership and in the corporation. However, the limited
partner generally does not have a role in selecting the management or One advantage to S becoming a corporation occurs when investors have
in influencing the direction of the enterprise. On a pro rata basis, outside income against which to use losses by the company. Even with
stockholders are able to select management and affect the direction of no outside income, stockholders still may find S to be advantageous. If
the enterprise. Also, partnership income is taxable to the limited dividends are paid, the stockholder under a S corporation is subject only
partners as personal income whereas corporate income is not taxed to taxation on the profits earned by the company. Under the corporate
unless distributed to the stockholders as dividends. method, the company pays taxes on its profits and then the owners pay
personal income taxes on the dividends paid to them.
3. What are some of the disadvantages of (a) a sole proprietorship?
(b) a partnership? (c) a limited liability company (LLC)? 11. Tax laws have become extremely complex. In addition, there is
little theoretical or moral justification for a substantial number of
With both a sole proprietorship and partnership, a major drawback is tax incentives (loopholes). Why and how are these incentives
the legal liability of the owners. It extends beyond the financial

Page 5 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


created? In your opinion, is there any indication that these is an indirect cost. When financial intermediation reduces these costs,
incentives will be eliminated? the market becomes more efficient. The market becomes more
complete when special types of financial instruments and financial
Tax incentives are the result of special interest groups influencing processes are offered in response to an unsatisfied demand by
legislators. For example, exporters influenced the passage of DISCs. investors. For example, the new product might be a zero-coupon bond
Doctors and attorneys influenced the passage of the Keogh pension and the new process, automatic teller machines.
plans. Some of these incentives benefit society as a whole; others
benefit only a few at the expense of the rest of society. It is hard to 17. What is the purpose of stock market exchanges such as the New
imagine all individuals placing the interest of the whole above their own York Stock Exchange?
interests. Therefore, it is difficult to perceive that tax incentives will be
discontinued. Further, some incentives can be used to benefit large These exchanges serve as secondary markets wherein the buyer and
groups of people. seller meet to exchange shares of companies that are listed on the
exchange. These markets have provided economies of time and scale in
12. What is the purpose of the carryback and the carryforward the past and have facilitated exchange among interested parties.
provisions in the tax laws?
18. In general, what would be the likely effect of the following
The purpose of the carryback and carryforward provisions is to allow occurrences on the money and capital markets?
the cyclical company with large profit swings to obtain most of the tax a. The savings rate of individuals in the country declines.
benefits available to a company with more steady profits. Also, the b. Individuals increase their savings at savings and loan
provision protects the company with a large loss in a given year. While associations and decrease their savings at banks.
if a company has steady losses it does not benefit from this provision, c. The government taxes capital gains at the ordinary income
the marginal company with profit swings does. tax rate.
d. Unanticipated inflation of substantial magnitude occurs, and
13. What is the purpose of financial markets? How can this purpose price levels rise rapidly.
be accomplished efficiently? e. Savings institutions and lenders increase transaction charges
for savings and for making loans.
Financial markets allow for efficient allocation in the flow of savings in
an economy to ultimate users. In a macro sense, savings originate from a. All other things being the same, the cost of funds (interest rates)
savings-surplus economic units whose savings exceed their investment would rise. If there are no disparities in savings pattern, the effect would
in real assets. The ultimate users of these savings are savings-deficit fall on all financial markets.
economic units whose investments in real assets exceed their savings. b. Given a somewhat segmented market for mortgages, it would result
Efficiency is introduced into the process through the use of financial in mortgage rates falling and rates on other financial instruments rising
markets. Since the savings-surplus and savings-deficit units are usually somewhat.
different entities, markets serve to channel these funds at the least cost c. It would lower the demand for common stock, bonds selling at a
and inconvenience to both. As specialization develops, efficiency discount, real estate, and other investments where capital gains are an
increases. Loan brokers, secondary markets, and investment bankers all attraction for investment. Prices would fall for these assets relative to
serve to expedite this flow from savers to users. fixed income securities until eventually the expected returns after taxes
for all financial instruments were in equilibrium.
14. Discuss the functions of financial intermediaries. d. Great uncertainty would develop in the money and capital markets
and the effect would likely be quite disruptive. Interest rates would rise
Financial intermediaries provide an indirect channel for the flow of dramatically and it would be difficult for borrowers to find lenders
funds from savers to ultimate users. These institutions include willing to lend at a fixed interest rate. Disequilibrium would likely to
commercial banks, savings and loan associations, life insurance continue to occur until the rate of inflation reduced to a reasonable
companies, pension and profit-sharing funds and savings banks. Their level.
primary function is the transformation of funds into more attractive e. Financial markets would be less efficient in channeling funds from
packages for savers. Services and economies of scale are side benefits savers to investors in real estate.
of this process. Pooling of funds, diversification of risk, transformation
of maturities and investment expertise are desirable functions that 19. Pick a financial intermediary with which you are familiar and
financial intermediaries perform. explain its economic role. Does it make the financial markets
more efficient?
15. A number of factors give rise to different interest rates or yields
being observed for different types of debt instruments. What are Answers to this question will differ depending on the financial
these factors? intermediary that is chosen. The economic role of all is to channel
savings to investments at a lower cost and/or with less inconvenience
Differences in maturity, default risk, marketability, taxability, and to the ultimate borrower and to the ultimate saver than would be the
option features affect yields on financial instruments. In general, the case in their absence. Their presence improves the efficiency of financial
longer the maturity, the greater the default risk, the lower the markets in allocating savings to the most productive investment
marketability and the more the return is subject to ordinary income opportunities.
taxation as opposed to capital gains taxation or no taxation, the higher
the yield on the instrument. If the investor receives an option (e.g., a 20. What is the distinction between the money market and the
conversion feature or warrant), the yield would be lower than capital market? Is the distinction real or artificial?
otherwise. Conversely, if the firm issuing the security receives an option,
such as a call feature, the investor must be compensated with a higher Money markets serve the short-term liquidity needs of investors. The
yield. Another factor – one not taken up in this chapter – is the coupon usual line of demarkation is one year; money markets include
rate. Lower the coupon rate, greater the price volatility of a bond, and instruments with maturities of less than a year while capital markets
all other things being the same, generally higher the yield. involve securities with maturities of more than one year. However, both
markets are financial markets with the same economic purpose so the
16. What is meant by making the financial markets more efficient? distinction of maturity is somewhat arbitrary. Money markets involve
More complete? instruments that are impersonal; funds flow on the basis of risk and
return. A bank loan, for example, is not a money-market instrument
The market becomes more efficient when the cost of financial even though it might be short-term.
intermediation is reduced. This cost is represented by the difference in
interest rate between what the ultimate saver receives and what the 21. How do transaction costs affect the flow of funds and the
ultimate borrower pays. Also, the inconvenience to one or both parties efficiency of financial markets?

Page 6 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


Transaction costs impede the efficiency of financial markets. The larger 3. Wallopalooza Financial, Inc., believes that it can successfully
they are, the less efficient are financial markets. Financial institutions “intermediate” in the mortgage market. At present, borrowers pay
and brokers perform an economic service for which they must be 7 percent on adjustable rate mortgages. The deposit interest rate
compensated. The means of compensation is transaction costs. If there necessary to attract funds to lend is 3 percent, also adjustable with
is competition among them, transaction costs will be reduced to market conditions. Wallopalooza’s administrative expenses,
justifiable levels. including information costs, are $2 million per annum on a base
business of $100 million in loans.
22. What are the major sources of external financing for business a. What interest rates on mortgage loans and on deposits would
firms? you recommend to obtain business?
b. If $100 million in loans and an equal amount of deposits are
The major sources are bank loans, bond issues, mortgage debt, and attracted with a mortgage rate of 6.5 percent and a deposit
stock issues. interest rate of 3.5 percent, what would be Wallopalooza’s annual
before-tax profit on the new business? (Assume that interest rates
23. In addition to financial intermediaries, what other institutions do not change.)
and arrangements facilitate the flow of funds to and from
business firms? Answer:
a. At $2 million in expenses per $100 million in loans, administrative
Financial brokers, such as investment bankers in particular as well as costs come to 2 percent. Therefore, just to break even, the firm must
mortgage bankers, facilitate the matching of borrowers in need of funds set rates so that (at least) a 2 percent difference exists between the
with savers having funds to lend. For this matching and servicing, the deposit interest rate and the mortgage rate. In addition, market
broker earns a fee that is determined by competitive forces. In addition, conditions dictate that 3 percent is the floor for the deposit rate, and 7
security exchanges and the over-the-counter market improve the percent is the ceiling for the mortgage rate. Suppose that Wallopalooza
secondary market and hence the efficiency of the primary market wished to increase the current deposit rate and lower the current
where securities are sold originally. mortgage rate by equal amounts while earning a before-tax return
spread of 1 percent. It would then offer a deposit rate of 3.5 percent
ILLUSTRATIONS and a mortgage rate of 6.5 percent. Of course, other answers are
possible, depending on your profit assumptions.
b. Before-tax profit of 1 percent on $100 million in loans equals $1
1. John Henry has a small housecleaning business that currently is a
million.
sole proprietorship. The business has nine employees, annual sales
of $480,000, total liabilities of $90,000, and total assets of
4. Suppose that 91-day Treasury bills currently yield 6 percent to
$263,000. Including the business, Henry has a personal net worth
maturity and that 25-year Treasury bonds yield 7.25 percent. Lopez
of $467,000 and nonbusiness liabilities of $42,000, represented by
Pharmaceutical Company recently has issued long-term, 25-year
a mortgage on his home. He would like to give one of his
bonds that yield 9 percent to maturity.
employees, Tori Kobayashi, an equity interest in the business.
a. If the yield on Treasury bills is taken to be the short-term, risk-
Henry is considering either the partnership form or the corporate
free rate, what premium in yield is required for the default risk and
form, where Kobayashi would be given some stock. Kobayashi has
lower marketability associated with the Lopez bonds?
a personal net worth of $36,000.
b. What premium in yield above the short-term, risk-free rate is
a. What is the extent of Henry’s exposure under the sole
attributable to maturity?
proprietorship in the case of a large lawsuit (say, $600,000)?
b. What is his exposure under a partnership form? Do the partners
Answer:
share the risk?
a. The premium attributable to default risk and to lower marketability
c. What is his exposure under the corporate form?
is 9% − 7.25% = 1.75%.
b. The premium attributable to maturity is 7.25% − 6% = 1.25%. In this
Answer:
case, default risk is held constant, and marketability, for the most part,
a. Henry is responsible for all liabilities, book as well as contingent. If the
is also held constant.
lawsuit were lost, he would lose all his net assets, as represented by a
net worth of $467,000. Without the lawsuit, he still is responsible for
$90,000 in liabilities if for some reason the business is unable to pay PROBLEMS
them.
b. He still could lose all his net assets because Kobayashi’s net worth is 1. Zaharias-Liras Wholesalers, a partnership, owes $418,000 to
insufficient to make a major dent in the lawsuit: $600,000 − $36,000 = various shipping companies. Armand Zaharias has a personal net
$564,000. As the two partners have substantially different net worths, worth of $1,346,000, including a $140,000 equity interest in the
they do not share equally in the risk. Henry has much more to lose. partnership. Nick Liras has a personal net worth of $893,000,
c. Under the corporate form, he could lose the business, but that is all. including the same equity interest in the business as his partner.
The net worth of the business is $263,000 − $90,000 = $173,000, and The partners have kept only a moderate equity base of $280,000
this represents Henry’s personal financial stake in the business. The in the business, with earnings being taken out as partner
remainder of his net worth, $467,000 − $173,000 = $294,000, would be withdrawals. They wish to limit their risk exposure and are
protected under the corporate form. considering the corporate form.
a. What is their liability now for the business? What would it be
2. Bernstein Tractor Company has just invested in new equipment under the corporate form?
costing $16,000. The equipment falls in the five-year property class b. Will creditors be more or less willing to extend credit with a
for cost recovery (depreciation) purposes. What depreciation change in organization form?
charges can it claim on the asset for each of the next six years?
Answer:
Answer: a. Under the partnership, $418,000 in actual liabilities. If sued, they
Depreciation charges for the equipment: could lose up to their full combined net worths. As a corporation, their
exposure is limited to the $280,000 in equity that they have in the
business.
b. Creditors should be less willing to extend credit, because the personal
net worths of the owners no longer back the claims.

2. The Loann Le Milling Company is going to purchase a new piece of


testing equipment for $28,000 and a new machine for $53,000. The
Page 7 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com
equipment falls in the three-year property class, and the machine
is in the five-year class. What annual depreciation will the company
be able to take on the two assets?

Answer:

Reference:
 Fundamentals of Financial Management 13th Edition, James C. Van
Horne and John M. Wachowicz, Jr.

Page 8 of 8- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com