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Chapter 2
The Financial Market Environment
Instructor’s Resources
Overview
Money and capital markets and their major components are introduced in this chapter. Firms need to raise capital in
order to survive. Financial institutions give firms access to the money they need to grow. However, greed can drive
financial managers and institutions to commit actions that get them into trouble and even force bankruptcy. These
bankruptcies result in limited capital flows to firms, and both they and the whole economy can suffer. Therefore,
financial institutions and markets should be well regulated. The final section covers a discussion of the impact of
taxation on the firm’s financial activities.
Suggested Answer to Opener-in-Review Question
Consider a buyer who purchased a home that month for $150,000, using $30,000 of her own funds as a down
payment and borrowing the remaining $120,000 from a bank via a 30-year mortgage. Two years later, prices
in Phoenix rose by 30 percent, and the house was worth $195,000. Assuming that after making two years of
payments on the 30-year mortgage, the outstanding mortgage balance was still $118,000. How much equity
does the buyer have in her home? What rate of return has she earned on her initial $30,000 investment?
Buyer’s equity in her home = $195,000 – $118,000 = $77,000
Rate of return = ($77,000 – $30,000) ÷ $30,000 = $156.67%
Answers to Review Questions
1. The key participants in financial transactions are individuals, businesses, and governments. These parties
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Chapter 2 The Financial Market Environment 14
2. Financial markets provide a forum in which suppliers of funds and demanders of loans and investments can
Primary market is the name used to denote the fact that a security is being issued by the demander of funds to
Secondary market refers to the trading of securities among investors subsequent to the primary market
3. The money market is created by a financial relationship between the suppliers and demanders of short-term
4. The capital market is a financial relationship created by a number of institutions and arrangements that allows
5. The broker market consists of national and regional securities exchanges. These organizations provide a
6. In addition to the U.S. capital markets, corporations can raise debt and equity funds in capital markets located
7. An efficient market will allocate funds to their most productive uses due to competition among
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Chapter 2 The Financial Market Environment 15
8. Securitization is the process of pooling mortgages and then selling claims against that pool in the secondary
9. Mortgage-backed securities represent claims on the cash flows generated by a pool of mortgages. As the
10. When a homeowner borrows money to buy a home, he borrows a fixed amount of money. As housing prices
11.As home prices decline, the value of homes may be less than the amount owed to the bank. Hence many
12. A crisis in the financial sector generally has a spillover effect on the other sectors of the economy. This can be
13. Due to their enormous impact, governments typically regulate financial institutions more than most economic
14. The Securities Act of 1933 was designed to regulate activity in the primary market, ensuring that sellers of
15. The ordinary income of a corporation is income earned through the sale of a firm’s goods or services. Taxes
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Chapter 2 The Financial Market Environment 16
16. Dividends received from another corporation, in which the shareholding firm’s position is less than one-fifth
17. The tax deductibility of corporate expenses reduces their actual after-tax cost. Corporate interest is a
Suggested Answer to Focus on Practice Box: Berkshire Hathaway: Can
Buffet Be Replaced?
The share price of BRKA has never been split. Why might the company refuse to split its shares to make
them more affordable to average investors?
The primary reason that Berkshire Hathaway does not split the price of its common stock is because Warren
Suggested Answer to Focus on Ethics Box: The Ethics of Insider
Trading
If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical?
Price efficiency does not necessarily imply that insider trading is either ethical or unethical. The efficient-market
Does allowing insider trading create an ethical dilemma for insiders?
It certainly could. Consider Fama’s point discussed in the case. If insider trading is allowed, insiders might have
Answers to Warm-Up Exercises
E2-1. Suppliers and demanders of funds
Answer: Individuals as a whole spend less than they earn. The excess is invested, making it available for
E2-2 Raising funds
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Chapter 2 The Financial Market Environment 17
Answer: Financial institutions, such as investment banks, provide expertise in the acquisition of funds.
E2-3 Money market vs. capital market
Answer: Money markets are short-term markets, so firms using these would be in need of funds for less than a
E2-4 Mortgage-backed securities
Answer: Questions you would ask include
a. Real estate location (after all, the three most important determinants of real estate price are
b. Percentage of properties in the region that are “under water” (homeowners owe more than they
c. Type of real estate (commercial properties offer less liquidity if the market turns sour,because
E2-5 Biggest benefit of government regulation
Answer: While the type and level of government regulation will always be debatable, the idea that we need and,
E2-6. Dividends received exclusion
Answer: While 100% of corporate interest income is taxed at ordinary tax rates, only 30% of corporate dividend
Solutions to Problems
P2-1. Corporate taxes
LG 6; Basic
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Chapter 2 The Financial Market Environment 18
a. Firm’s tax liability on $92,500 (from Table 2.1):
b. After-tax earnings: $92,500 – $19,700 $72,800
P2-2. Average corporate tax rates
LG 6; Basic
a. Tax calculations using Table 2.1:
$10,000: Tax liability: $10,000 0.15 $1,500
$80,000: Tax liability: $13,750 [0.34 (80,000 – $75,000)]
$300,000: Tax liability: $22,250 + [0.39 ($300,000 – $100,000)]
After-tax earnings: $300,000 – $100,250 $199,750
Average tax rate: $100,250 ÷ $300,000 33.4%
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Chapter 2 The Financial Market Environment 19
$500,000: Tax liability: $113,900 [0.34 ($500,000 – $335,000)]
$1,500,000: Tax liability: $113,900 [0.34 ($1,500,000 – $335,000)]
$10,000,000: Tax liability: $113,900 + [0.34 ($10,000,000 – $335,000)]
$20,000,000: Tax liability: $6,416,667 [0.35 ($20,000,000 – $18,333,333)]
b.
As income increases, the rate reaches 35%.
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Chapter 2 The Financial Market Environment 20
P2-3. Marginal corporate tax rates
LG 6; Basic
a.
Tax Calculation
Pre-Tax
Income Base Tax %
Amount
Over Base
Total
Tax
Marginal
Rate
$ 15,000 $ 0 (0.15 15,000) $ 2,250 15.0%
b.
P2-4. Interest vs. dividend income
LG 6; Intermediate
a. Tax on operating earnings: $490,000 0.40 tax rate $196,000
b. and c.
(b)
Interest Income
(c)
Dividend Income
Before-tax amount $20,000 $20,000
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Chapter 2 The Financial Market Environment 21
d. The after-tax amount of dividends received, $17,600, exceeds the after-tax amount of interest,
e. Total tax liability:
P2-5. Interest vs. dividend expense
LG 6; Intermediate
a. EBIT $50,000
*This is also earnings available to common stockholders.
b. EBIT $50,000
P2-6. Capital gains taxes
LG 6; Basic
a. Capital gain:
b. Tax on sale of asset:
P2-7. Capital gains taxes
LG 6; Basic
a. and b.
Asset
Sale Price
(1)
Purchase Price
(2)
Capital Gain
(1) – (2)
(3)
Tax
(3) 0.40
(4)
A $3,400 $3,000 $400 $160
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Chapter 2 The Financial Market Environment 22
P2-8. Ethics problem
LG 5; Intermediate
The primary ethical issue is whether the insider is basing his buy or sale of company shares on internal
Case
Case studies are available on www.myfinancelab.com.
The Pros and Cons of Being Publicly Listed
a. Being a publicly listed company provides access to the money the company needs to grow. Shareholders also
b. There are many disadvantages to going public. One, there is no guarantee that shareholders will want to
c. Not enough information is provided to determine whether Robo-Tech meets the listing requirements to be on
d. Capital market efficiency is important for many reasons. If the market is efficient, prices are an unbiased estimate
Spreadsheet Exercise
The answer to Chapter 2’s Hemingway Corporation spreadsheet problem is located on the Instructor’s Resource
Center at www.pearsonhighered.com/irc under the Instructor’s Manual.
Group Exercise
There is no group exercise for Chapter 2.
Integrative Case 1: Merit Enterprise Corp.
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Chapter 2 The Financial Market Environment 23
a. There are limited benefits and risks with Option 1. With the loan, Merit will obtain the money needed and
b. Option 2 has a much greater potential to impact Merit. If the firm’s recent financial performance has resulted
On the other hand, going public opens Merit up to a variety of issues. There is a cost of the initial public issue
Of course, the typical disadvantages of the corporate form of ownership would apply. Merit would pay
c. Sara Lehn should make her decision on the basis of which option will maximize the wealth of the current
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