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

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. Besley Ch. 2

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 Besley Ch. 2

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 Besley Ch. 2

Financial Institutions Three Primary Ways Capital Is Transferred Between Savers and Borrowers: Direct Transfer Investment Bank Financial Intermediary (ie. bank; mutual fund) Besley Ch. 2

Forms of Capital Transfer Direct Transfer Business Savers Securities (Stocks/Bonds) Cash Investment Bank Business Savers Securities Cash Financial Intermediary Financial Intermediary Business Savers Business’s Securities Cash Intermediary’s Securities Besley Ch. 2

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. Besley Ch. 2

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 Financial Intermediaries mitigate risk and create liquidity. Besley Ch. 2

The Stock Market Two types of stock markets: Organized Exchanges NYSE AMEX Over-the-Counter NASDAQ Besley Ch. 2

Organized Security Exchanges Formal organizations with physical locations where auction markets are conducted in designated (“listed”) securities. Besley Ch. 2

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. Besley Ch. 2

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 Besley Ch. 2

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 Besley Ch. 2

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 Besley Ch. 2

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. Besley Ch. 2

Interest Rate Level Market A: Low-Risk Securities Market B:High-Risk Securities Interest Rate, kA Interest Rate, kB % % S1 S1 kB = 12 kA = 10 8 Figure 2-2 (pg.) 47 Shows how Supply and Demand interact to set interest rates in Capital Markets. Markets A and B represent two of the many capital markets. Interest Rate – either k or i Market A (Low Risk Securities) D1 initially 10%: Borrowers whose credit qualifies for this market can obtain funds @10% Lenders who want to invest with low risk can get a 10% return. Market B (High Risk Securities) Riskier borrowers (who don’t qualify for Market A) must seek funds in Market B at a higher rate (12%) Riskier lenders want the 2% premium for the additional risk; with the understanding that they may receive much less (or much more). Business Recession (Market A): Demand for funds decline à shifting the demand curve to the left (D2) à Market Equilibrium shift to 8% If Supply of funds tighten à the Supply Curve would shift to the left à interest rate would rise and lower the level of borrowing. Capital Markets are independent. If both Markets A and B are in equilibrium before the demand shift to D2 à Risk Premium of 2% between the markets. After shift the risk premium is 4%. 4% would cause some investors in Market A to shift to Market B for the higher interest rate. Which would cause: Market A’s supply curve to shift left. Market B’s supply curve to shift right. Shift of capital between markets would cause the risk premium to return to approximately 2%. D1 D1 D2 Dollars Dollars Besley Ch. 2

Note on Interest Rates Short-term rates are responsive to current economic conditions. Rise during economic booms Drop during recessions Besley Ch. 2

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: k the quoted interest rate for a given security k* the real risk free interest rate IP inflation premium DRP default risk premium LP liquidity premium MRP maturity risk premium Besley Ch. 2

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. Can be thought of as the rate of interest that would exist on short-term US Treasury securities in an inflation free world. It is difficult to measure the real risk-free rate precisely, but most experts think that k* has fluctuated in the range of one to four percent in the US in recent years. Besley Ch. 2

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 There is one security that is free of most risks: a US T-Bill, which is a short-term security issued by the US government. T-Bonds are free of default risk and liquidity risk, but are exposed to some risks due to changes in the general level of interest rates over time. Besley Ch. 2

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. Besley Ch. 2

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. Besley Ch. 2

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. Besley Ch. 2

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. Besley Ch. 2

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 Besley Ch. 2

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. Besley Ch. 2

The Yield Curve Interest Rate (%) 1 5 10 20 Term to Interest Rate Maturity Mar 1980 Mar 1999 6 months 15.0% 4.6% 1 year 14.0 4.9 5 years 13.5 5.2 10 years 12.8 5.5 20 years 12.5 5.9 Interest Rate (%) 16 14 12 10 8 6 4 2 Yield Curve for March 1980 12% inflation Inverted Yield Curve: Downward-sloping Historically LT rates are above ST rates à Normal = upward-sloping. Yield Curve for March 1999 2% inflation Normal Yield Curve: Upward-sloping 1 5 10 20 Besley Ch. 2

Term Structure Theories Three major theories to explain the shape of the yield curve: The Expectations Theory The Liquidity Preference Theory Market Segmentation Theory Besley Ch. 2

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 years ASSUMES: MRP = 0, DRP and LP for US Treasury Securities = 0. Besley Ch. 2

Calculating Interest Rates Under the Expectations Theory Step 1: Find the Average Expected Inflation Rate over the period (1 to N years) IPn = N S INFLt t=1 Besley Ch. 2

Calculating Interest Rates Under the Expectations Theory Assumptions: 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). Besley Ch. 2

Calculating Interest Rates Under the Expectations Theory Step 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% Besley Ch. 2

Calculating Interest Rates Under the Expectations Theory Step 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 Besley Ch. 2

Yield Curve Yield Curve Interest Rate (%) Years to Maturity Besley Ch. 2

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. Besley Ch. 2

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 Besley Ch. 2

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 à Higher Rates/Recession à Lower Rates S-T rates change more sharply than L-T rates Besley Ch. 2

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. When Interest rates rise sharply, investors can get higher returns in the bond market; therefore they sell stocks and transfer capital into the bond market. Besley Ch. 2

The Federal Income Tax System Individual Income Taxes Corporate Income Taxes Besley Ch. 2

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 Besley Ch. 2

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? Besley Ch. 2

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 Besley Ch. 2

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

What is your Tax Liability? =Base tax amount + tax rate(taxable income - $25,750) Tax Liability = $3,862.50 + 0.28($35,000 -$25,750) = $6,452.50. Marginal Tax Rate is the tax rate applied to the last unit of income = 28.0% Average Tax Rate = Total tax liability / total taxable income = $6,452.50 / $35,000 = 18.4% Besley Ch. 2

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 Besley Ch. 2

Corporate Income Taxes Besley Ch. 2

Corporate Tax Rates Besley Ch. 2

Corporate Tax Liability = Base tax amount +tax rate (taxable income - $100,000) Tax Liability = $22,250 + 0.39($108,000 - $100,000) = $ 25,370 Besley Ch. 2

Corporate Tax Liability Interest and Dividend Income Received by a Corporation Ownership Exclusion 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. Besley Ch. 2

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 Besley Ch. 2