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Introduction to Managerial Finance

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

Besley: Chapter 2

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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.

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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

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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

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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)

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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

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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 investorsBuy these securities from the corporationResell these securities to investors.

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

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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 BanksSavings and Loans (S&Ls)Credit UnionsPension FundsLife Insurance CompaniesMutual Funds

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The Stock Market

Two types of stock markets:Organized Exchanges

NYSEAMEX

Over-the-CounterNASDAQ

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Organized Security Exchanges

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

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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.

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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

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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

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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

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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 capitalSavers’ time preferences for current versus

future compensationThe riskiness of the loanThe expected future rate of inflation.

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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

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Note on Interest Rates

Short-term rates are responsive to current economic conditions.

Rise during economic boomsDrop during recessions

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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

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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.

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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

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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.

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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%

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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.

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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.

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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

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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.

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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

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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

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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.

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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

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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).

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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%

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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

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Yield Curve

0

5

10

15

0 1 5 10 15 20

Inte

rest

Rate

(%

)

Years to Maturity

Yield Curve

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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.

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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 expectationsLiquidity preferencesSupply and Demand conditions in long-term and short-term

markets

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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

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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.

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The Federal Income Tax System

Individual Income Taxes

Corporate Income Taxes

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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

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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?

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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

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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?

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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?

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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

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Income $100,000

Taxable dividend income 3,000

Interest income 5,000

Taxable Income $108,000

Corporate Income Taxes

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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

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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

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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.

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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