Chapter2

TheFinancialMarketEnvironment
Instructors Resources
Overview
[Link]
[Link],
greedcandrivefinancialmanagersandinstitutionstocommitactionsthatgetthemintotroubleandeven
[Link]
[Link]
activities.

Suggested Answer to Opener in Review Question

Whatroledoyouthinkmarketefficiency(orinefficiency)playedinthe10percentfallof
JPMorganssharepriceinasingleday?
Inanefficientmarket,[Link]
[Link]
[Link]
thenewinformation,[Link]
thatinvestorpsychologyresultedinadelayedresponsetonewinformationthatwasbuildingupoverprior
days,andperhapsanoverreactiontoeventsofoneday.

Answers to Review Questions

1. Thekeyparticipantsinfinancialtransactionsareindividuals,businesses,[Link]
[Link],which
meansthattheysavemoredollarsthantheyborrow,whilebothbusinessesandgovernmentsarenet
[Link]
fundsrequiredbybusinessesandgovernments.
[Link]
andcompanieswiththeirbankingneeds,whilethelatterconcentrateseffortsintheareaofassisting
corporationswithraisingfunds.Untilthelate1990s,theGlassSteagallActcreatedaseparationbetween
[Link],wherenondeposittakingenterpriseslendmoneytofirmsneeding
cash,hasgrowntobeaslargeasthetraditionalbankingsystem.

Chapter2TheFinancialMarketEnvironment13

2. Financialmarketsprovideaforuminwhichsuppliersoffundsanddemandersofloansand
investmentscantransactbusinessdirectly.

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Primarymarketisthenameusedtodenotethefactthatasecurityisbeingissuedbythedemander
[Link]
commonstocktothepublic.
Secondarymarketreferstothetradingofsecuritiesamonginvestorssubsequenttotheprimary
[Link],nonewfundsarebeingraisedbythedemanderof
[Link]
buyingcommonstockofMicrosoftthroughabrokerfromindividualB.
[Link]
findfinancialinstitutionsactivelyparticipatinginboththemoneymarketandthecapitalmarketas
[Link]
[Link]
mustusethestructureofthefinancialmarketplacetofindasupplieroffunds.
3. Themoneymarketisafinancialrelationshipbetweenthesuppliersanddemandersofshorttermdebt
securitiesmaturinginoneyearorless,[Link],commercialpaper,andnegotiable
[Link]
marketandisusedforshorttermbanktimedepositsdenominatedindollarsorothermajorcurrencies.
4. Thecapitalmarketisafinancialrelationshipcreatedbyanumberofinstitutionsandarrangements
thatallowsthesuppliersanddemandersoflongtermfunds(withmaturitiesgreaterthanoneyear)
[Link]
preferredstock.
5. [Link]
location,suchastheNewYorkStockExchange,tobringtogetherthebuyersandsellersofdebtand
[Link],allocatescarcecapital,determineandpublicize
securityprices,andaidinnewfinancing.
Bycontrast,dealermarketsareelectronicmarketsforthebuyersandsellersofsecuritiesnotlistedon
[Link],physicaltradinglocationsarereplacedbysecuritydealers
whooffertobuyorsellsecuritiesatstatedbid/[Link],sell
themtootherdealers,[Link]
marketarelistedonNasdaq,theNationalAssociationofSecuritiesDealersAutomatedQuotation
System.

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6. [Link],corporationscanraisedebtandequityfundsincapitalmarkets
[Link].
Corporateandgovernmentbondsissuedinthismarketaredenominatedindollarsorothermajor
currenciesandsoldtoinvestorsoutsidethecountryinwhosecurrencythebondsaredenominated.
Foreignbondmarketsalsoprovidecorporationswiththeopportunitytotapothercapitalsources.
Corporationsorgovernmentsissuebondsdenominatedinthelocalcurrencyandsoldonlyinthat
[Link]
inseveralcountries,providingadiversifiedinvestorbaseandadditionalopportunitiestoraiselarger
amountsofcapital.
7. Anefficientmarketwillallocatefundstotheirmostproductiveusesduetocompetitionamong
[Link]
[Link],[Link]
[Link]
anddemandcontinuallyimpactpricesinanefficientmarket.
[Link]
[Link]
psychologicalandotherreasons,fewinvestorshavebeenabletoearnariskadjusted,positiverate
ofreturn.
8. Securitizationistheprocessofpoolingmortgagesandthensellingclaimsagainstthatpoolinthe
[Link].
9. [Link]
thehomeownerspayofftheirmortgages,[Link]
riskassociatedwithmortgagebackedsecuritiesisthathomeownersmaynotrepaytheirloans.
10. Whenahomeownerborrowsmoneytobuyahome,[Link]
pricesrise,[Link]
[Link],
mortgagedefaultratesarerelativelylow.
11. Ashomepricesdecline,[Link]
[Link]
[Link],thevalueof
[Link],borrowershavingtroublemakingmortgagepayments
[Link],andthenumber
[Link]
valuable,increasingthenumberofhomeownerswithhousesworthlessthantheamountowedtothe
[Link].

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12. Asmortgagebackedsecuritydelinquencyratesrose,thevalueofstillsolventmortgageback
[Link],includingfinancial
[Link],requiringhigherstandardsfor
[Link],firmsbegantohoard
[Link].
Throughouttheeconomyrevenuesfallasfinancialinstitutionscutbackonlending.
13. Duetotheirenormousimpact,governmentstypicallyregulatefinancialinstitutionsmorethanmost
[Link]
[Link],itisnotsurprisingthatan
aboveaverageamountoflegislationwasenactedinthe1930s.
14. TheSecuritiesActof1933wasdesignedtoregulateactivityintheprimarymarket,ensuringthat
sellersofnewsecuritiesprovidedextensivedisclosure.TheSecuritiesExchangeActof1934
[Link]
SecuritiesExchangeCommissiontoenforcefederalsecuritieslaws.
15. Theordinaryincomeofacorporationisincomeearnedthroughthesaleofafirmsgoodsorservices.
Taxesoncorporateordinaryincomehavetwocomponents:afixedamountonthebasefigureforits
incomebracketlevel,plusaprogressivepercentage,rangingfrom15%to39%,appliedtotheexcess
[Link]
[Link].
[Link]
incomeof$10millionorless,itrangesfrom15%to34%.Forfirmswithtaxableincomeinexcessof
$10million,itrangesbetween34%and35%.Themarginaltaxrateistherateatwhichadditional
incomeistaxed.

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21Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

16. Dividendsreceivedfromanothercorporation,inwhichtheshareholdingfirmspositionislessthan
onefifthofoutstandingshares,issubjecttoa70%[Link]
30%ofwhatitwouldbeonfullytaxableincome.
17. [Link]
taxdeductibleexpense,whiledividendsarenot.

Suggested Answer to Focus on Practice Box: Berkshire Hathaway

Can Buffet Be Replaced?
[Link]
makethemmoreaffordabletoaverageinvestors?
TheprimaryreasonthatBerkshireHathawaydoesnotsplitthepriceofitscommonstockisbecause
WarrenBuffettsphilosophyisthatastocksplitismeaninglessfinanciallyandonlyservesasawayto
[Link]
[Link]
shareholders,therearelesspeoplethatthecompanymanagementmustanswerto,andinvestorswhocan
affordthesteeppriceoftheBerkshireHathawaystockarelikelytobeseriousindividualinvestorsor
institutionalinvestorssuchasmutualfunds.

Suggested Answer to Focus on Ethics Box: The Ethics of Insider

Trading
Ifefficiencyisthegoaloffinancialmarkets,isallowingordisallowinginsidertradingmoreunethical?
[Link]
[Link]
tradingarguethatitwillallowprivateinformationtobecomepublicfaster,allowingpricestomorerapidly
adjusttothisinformation.
Doesallowinginsidertradingcreateanethicaldilemmaforinsiders?
[Link],insidersmight
havetheincentivetoholdbackinformationinordertoprofitfromtheinformationbeforereleasingitto
[Link],stockpricescouldimpoundinformationmoreslowlywheninsidertrading
ispermitted.

Answers to Warm-Up Exercises

E21.

Suppliersanddemandersoffunds

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23Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

Answer: [Link],makingit
[Link],fewerdollarswillbeavailablefor
[Link]
therequiredreturn(i.e.,requiredreturnofinvestorsbuybonds).Overtime,employment,
salaries,andgrossdomesticproductwoulddecline.

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25Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

E22

Raisingfunds

Answer: Financialinstitutions,suchasinvestmentbanks,provideexpertiseintheacquisitionoffunds.
Investmentbankinginstitutionsareabletousetheexpertisedevelopedthroughtheacquisition
offundsformanyfirmstoreducetheeffortandcostofacquiringfundsforanysinglebusiness.
TheinvestmentbankinginstitutionwillallowtheGagaEnterprisesCFOtoraisemoremoney
atalowercostperdollarraised.
E23

[Link]

Answer: Moneymarketsareshorttermmarkets,sofirmsusingthesewouldbeinneedoffundsforless
[Link],suchasRVdealerships
buildinginventorypriortothespring/[Link],a
[Link]
markets,bycontrast,aretypicallyusedforfixedassets,whichacompanywilluseoverseveral
years.
E24

Mortgagebackedsecurities

Answer: Questionsyouwouldaskinclude:
a. Realestatelocation(afterall,thethreemostimportantdeterminantsofrealestatepriceare
location,location,location)
b. Percentageofpropertiesintheregionthatareunderwater(homeownersowemorethan
theyborrowed)orinforeclosure
c. Typeofrealestate(commercialpropertiesofferlessliquidityifthemarketturnssour,
becauseemptyhomescanberentedforrevenue)
d. Precedenceinbankruptcy(wouldotherlendershaveaseniorclaimtopropertiesin
bankruptcy?)
e. Qualityofrealestate(isitingoodcondition,orwouldthereneedtoberepairspriorto
sale?)
f.

Creditworthinessofborrowers(howlikelyisitthatborrowerswilllosetheirjobandbe
unabletomakepaymentsonatimelybasis?)

g. Whatpercentageofborrowersarebehindontheirmortgagepayments
h. Willborrowerssoonbeexperiencinganinterestrateincreasebecausetheytookouta
mortgagewithalowinitialratethatwasadjustableafteraperiodoftime
E25.

Dividendsreceivedexclusion

Answer: While100%ofcorporateinterestincomeistaxedatordinarytaxrates,only30%ofcorporate
[Link]
only1.5%[5%(10.7)]ofthe5%[Link]
[Link],Pruro,[Link]
aftertaxincomeifitchoosestheRestonstockpaying5%dividendsoverthepromissorynote
paying5%interest.

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27Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

Solutions to Problems
P21.

Corporatetaxes
LG6;Basic
a. Firmstaxliabilityon$92,500(fromTable2.1):
Totaltaxesdue$13,750[0.34($92,500$75,000)]
$13,750(0.34$17,500)
$13,750$5,950
$19,700
b. Aftertaxearnings:$92,500$19,700$72,800
c.

Averagetaxrate:$19,700$92,50021.3%

d. Marginaltaxrate:34%
P22.

Averagecorporatetaxrates
LG6;Basic
a.

TaxcalculationsusingTable2.1:
$10,000:

Taxliability:

$10,0000.15$1,500

Aftertaxearnings: $10,000$1,500$8,500

$80,000:

Averagetaxrate:

$1,500$10,00015%

Taxliability:

$13,750[0.34(80,000$75,000)]
$13,750(0.34$5,000)
$13,750$1,700
$15,450Totaltax

Aftertaxearnings: $80,000$15,450$64,550

$300,000:

Averagetaxrate:

$15,450$80,00019.3%

Taxliability:

$22,250+[0.39($300,000$100,000)]
$22,250(0.39$200,000)
$22,250$78,000
$100,250Totaltax

Aftertaxearnings: $300,000$100,250$199,750
Averagetaxrate:

$100,250$300,00033.4%

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$500,000:

Taxliability:

$113,900[0.34($500,000$335,000)]
$113,900(0.34$165,000)
$113,900$56,100
$170,000Totaltax

Aftertaxearnings: $500,000$170,000$330,000

$1,500,000:

Averagetaxrate:

$170,000$500,00034%

Taxliability:

$113,900[0.34($1,500,000$335,000)]
$113,900(0.34$1,165,000)
$113,900$396,100
$510,000Totaltax

Aftertaxearnings: $1,500,000$510,000$990,000
Averagetaxrate:
$10,000,000: Taxliability:

$510,000$1,500,00034%
$113,900+[0.34($10,000,000$335,000)]
$113,900(0.34$9,665,000)
$113,900$3,286,100
$3,400,000Totaltax

Aftertaxearnings: $10,000,000$3,400,000$6,600,000
Averagetaxrate:
$20,000,000: Taxliability:

$3,400,000$10,000,00034%
$6,416,667[0.35($20,000,000$18,333,333)]
$6,416,667(0.35$1,666,667)
$6,416,667583,333
$7,000,000Totaltax

Aftertaxearnings: $20,000,000$7,000,000$13,000,000
Averagetaxrate:

$7,000,000$20,000,00035%

b.

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Asincomeincreases,theratereaches35%.

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P23.

Marginalcorporatetaxrates
LG6;Basic
a.
TaxCalculation
Pretax
Income

BaseTax

$15,000
60,000
90,000
200,000
400,000
1,000,000
20,000,000

$0
7,500
13,750
22,250
113,900
113,900
6,416,667

%
(0.15
(0.25
(0.34
(0.39
(0.34
(0.34
(0.35

Amount
overBase

15,000)
10,000)
15,000)
100,000)
65,000)
665,000)
1,666,667)

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Total
Tax

Marginal
Rate

$2,250
10,000
18,850
61,250
136,000
340,000
7,00,0000

15.0%
25.0%
34.0%
39.0%
34.0%
34.0%
35.0%

35Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

b.

Asincomeincreasesto$335,000,themarginaltaxrateapproachesandpeaksat39%.For
incomeinexcessof$335,000,themarginaltaxratedeclinesto34%,andafter$10million
themarginalrateincreasesslightlyto35%.
P24.

[Link]
LG6;Intermediate
a.

Taxonoperatingearnings:$490,0000.40taxrate$196,000

[Link].

Beforetaxamount
Less:Applicableexclusion
Taxableamount
Tax(40%)
Aftertaxamount

(b)
InterestIncome

(c)
DividendIncome

$20,000
0
20,000
8,000
12,000

$20,000
14,000
6,000
2,400
17,600

(0.70$20,000)

d. Theaftertaxamountofdividendsreceived,$17,600,exceedstheaftertaxamountofinterest,
$12,000,duetothe70%[Link]
stockinvestmentsbyonecorporationinanotherrelativetobondinvestments.
e.

Totaltaxliability:
Taxesonoperatingearnings(froma.)

$196,000

Taxesoninterestincome(fromb.)

8,000

Taxesondividendincome(fromc.)

2,400

Totaltaxliability

$206,400

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P25.

[Link]
LG6;Intermediate
a. EBIT

$40,000

Less:Interestexpense

10,000

Earningsbeforetaxes

$30,000

Less:Taxes(40%)

12,000

Earningsaftertaxes*

$18,000

Thisisalsoearningsavailabletocommonstockholders.

b. EBIT

$40,000

Less:Taxes(40%)

16,000

Earningsaftertaxes

$24,000

Less:Preferreddividends

10,000

Earningsavailablefor
commonstockholders

$14,000

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P26.

Capitalgainstaxes
LG6;Basic
a.

Capitalgain:
AssetX$2,250$2,000$250
AssetY$35,000$30,000$5,000

b. Taxonsaleofasset:
AssetX$2500.40$100
AssetY$5,0000.40$2,000
P27.

Capitalgainstaxes
LG6;Basic
[Link].

Asset
A
B
C
D
E

SalePrice
(1)
$3,400
12,000
80,000
45,000
18,000

PurchasePrice
(2)
$3,000
12,000
62,000
41,000
16,500

CapitalGain
(1)(2)
(3)
$400
0
18,000
4,000
1,500

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Tax
(3)0.40
(4)
$160
0
7,200
1,600
600

41Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

P28.

Ethicsproblem
LG5;Intermediate
Theprimaryethicalissueiswhethertheinsiderisbasinghisbuyorsaleofcompanyshareson
[Link]
public,[Link]
awareofthelikelihoodofafavorableacquisition,andunethicallybuycompanysharesonthat
[Link],insidersalesbaseduponsoontobereleasedinformationabout
thelossofanimportantcontracttoacompetitor,wouldalsobeunethical.

Case
[Link].

The Pros and Cons of Being Publicly Listed

a. [Link]
providecashwithouthavinganabilitytotakethecompanytobankruptcycourtifapaymentisnot
[Link]
public,[Link],withoutgoingpublic,itisdifficultto
determinethevalueofthefirm.
b. [Link],thereisnotguaranteethatshareholderswillwant
[Link],[Link]
[Link]
thatanindividualorfirmmightpurchaseallthepubliclyavailableshares,oratleastenoughtocontrol
theboardofdirectors,andremovethefounderfromthemanagementteam.
c. NotenoughinformationisprovidedtodeterminewhetherRoboTechmeetsthelistingrequirements
[Link]
numberofpotentialinvestors.
d. [Link],pricesareanunbiased
[Link]
[Link]
andinthefuture,asitcontinuestoneedfundstofinanceexpansions.
(Studentsmayexpandontheseanswers.)

Spreadsheet Exercise
TheanswertoChapter2sMonsantospreadsheetproblemislocatedontheInstructorsResourceCenter
[Link]/ircundertheInstructorsManual.

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43Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

Group Exercise
ThereisnogroupexerciseforChapter2.

Integrative Case 1: Merit Enterprise Corp.

a. [Link],Meritwillobtainthemoney
[Link]
[Link],
however,Meritwouldhavelessaccesstocapitalmarketswhenitapparentlyneedsalargecash
infusiontoenablealargeproductionexpansion.
b. [Link]
resultedinthisbeinganidealtimetogopublic,simplyborrowingtheneededfundswouldholdback
[Link],thenewownerswouldnotbe
[Link],thenewownersmaynotbepaidadividendatallfor
[Link],beingpublicallowsemployeestobenefitiftheirfirmsucceeds.
Otherbenefitsincludethefactthatincorporations,[Link]
[Link]
[Link]
lifetimeofthecurrentowner(s).
Ontheotherhand,[Link]
[Link]
[Link],amajorityofsharesmightbeobtainedbyasingleindividualor
business,effectivelyacquiringMerit.
Ofcourse,[Link]
[Link].
c. SaraLehnshouldmakeherdecisiononthebasisofwhichoptionwillmaximizethewealthofthe
[Link]
[Link]
[Link],SarashouldproposethatMeritgoespublicattheupcomingmeetingof
theboardofdirectors.

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