Financial Market Environment - Chapter 2
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Questions and Answers

Which of the following is considered a marketable security by investors?

  • Real estate
  • Treasury bills (correct)
  • Collectible items
  • Cash value life insurance

The Eurocurrency market is a regulated market for short-term bank deposits.

False (B)

What are the main types of securities traded in the capital market?

Bonds, common stock, and preferred stock.

A bond issued by a company that pays investors $45 every six months is considered a ______.

<p>semiannual bond</p> Signup and view all the answers

Match the following securities with their descriptions:

<p>Bonds = Long-term debt instruments used by businesses and governments Common stock = Units of ownership interest in a corporation Preferred stock = Ownership that has features of both a bond and common stock Treasury bills = Short-term government securities</p> Signup and view all the answers

What is the annual interest received by investors from Lakeview Industries' bond with a 9% coupon rate and a $1,000 par value?

<p>$90 (D)</p> Signup and view all the answers

Berkshire Hathaway's Class A common stock has undergone multiple splits since the 1980s.

<p>False (B)</p> Signup and view all the answers

Who are the current leaders of Berkshire Hathaway?

<p>Warren Buffett and Charlie Munger.</p> Signup and view all the answers

What is the primary role of capital markets from a firm's perspective?

<p>To be a liquid market for external financing (D)</p> Signup and view all the answers

An efficient market always reflects the true value of securities.

<p>False (B)</p> Signup and view all the answers

What emerging field combines ideas from finance and psychology?

<p>Behavioral finance</p> Signup and view all the answers

The laws prohibiting insider trading were established in the ______.

<p>1930s</p> Signup and view all the answers

What was one of the failures leading to the recent financial crisis?

<p>Underestimating the risk of mortgage-backed securities (D)</p> Signup and view all the answers

Match the following terms with their definitions:

<p>Capital Markets = Liquid markets for financing Behavioral Finance = Study of psychological influences in finance Insider Trading = Trading based on non-public information Efficient Market = Market reflecting true value through competition</p> Signup and view all the answers

Insider trading can lead to ethical dilemmas for those who possess inside information.

<p>True (A)</p> Signup and view all the answers

What was the trading profit earned by Bryan Shaw from insider trading?

<p>$1.3 million</p> Signup and view all the answers

What is the primary benefit of tax-deductible expenses for profitable firms?

<p>Reduced after-tax cost (C)</p> Signup and view all the answers

Dividends paid by corporations are considered tax-deductible expenses.

<p>False (B)</p> Signup and view all the answers

What is a capital gain?

<p>The amount by which the sale price of an asset exceeds its purchase price.</p> Signup and view all the answers

A capital gain occurs when an asset is sold for a price higher than its ________ price.

<p>purchase</p> Signup and view all the answers

Which of the following describes the difference between money markets and capital markets?

<p>Money markets are for temporary savings, and capital markets are for long-term financing. (C)</p> Signup and view all the answers

What was a significant event that affected the financial system in 2008?

<p>The financial crisis and recession.</p> Signup and view all the answers

Match the following financial concepts with their descriptions:

<p>Tax-Deductible Expenses = Expenses that reduce taxable income Capital Gains = Profit from selling an asset above its purchase price Money Market = Short-term borrowing and lending Capital Market = Long-term borrowing and lending</p> Signup and view all the answers

Ross Company experienced a capital loss from selling an asset for more than its purchase price.

<p>False (B)</p> Signup and view all the answers

What was one significant effect of financial institutions lowering their lending standards?

<p>Rise in mortgage delinquencies (D)</p> Signup and view all the answers

The Gramm-Leach-Bliley Act reinforced the separation between commercial and investment banks.

<p>False (B)</p> Signup and view all the answers

What is the primary function of broker markets?

<p>To bring buyers and sellers together for trading securities (D)</p> Signup and view all the answers

What is the primary function of the Securities and Exchange Commission (SEC)?

<p>Enforcing federal securities laws</p> Signup and view all the answers

The Glass-Steagall Act created the FDIC and imposed a separation between __________ and __________ banks.

<p>commercial; investment</p> Signup and view all the answers

The Nasdaq operates as a centralized trading floor similar to the NYSE.

<p>False (B)</p> Signup and view all the answers

Match the following acts with their primary focus:

<p>Securities Act of 1933 = Regulating the sale of securities in the primary market Securities Exchange Act of 1934 = Regulations for transactions in the secondary market Glass-Steagall Act = Protection of depositors and separation of bank types Gramm-Leach-Bliley Act = Repealing elements of Glass-Steagall Act</p> Signup and view all the answers

What is the total market value of securities listed on the NYSE Euronext as of 2012?

<p>$14.1 trillion</p> Signup and view all the answers

What is the range of corporate tax rates for corporations?

<p>15 to 35 percent (B)</p> Signup and view all the answers

In dealer markets, buyers and sellers have their orders executed by __________.

<p>securities dealers</p> Signup and view all the answers

What metric is used to determine the largest stock market?

<p>The total market value of securities listed (B)</p> Signup and view all the answers

Capital gains are taxed at a lower rate than ordinary corporate income.

<p>False (B)</p> Signup and view all the answers

The Eurobond market primarily deals in bonds issued in the investor's home currency.

<p>False (B)</p> Signup and view all the answers

What happened to the value of mortgage-backed securities when home prices fell?

<p>The value plummeted.</p> Signup and view all the answers

Which exchange is the second largest in the world as of 2012?

<p>Nasdaq</p> Signup and view all the answers

Match the following exchanges with their respective market values (as of 2012):

<p>NYSE Euronext = $14.1 trillion Nasdaq = $4.6 trillion Tokyo Stock Exchange = $3.5 trillion London Stock Exchange = $3.3 trillion</p> Signup and view all the answers

What is the marginal tax rate for Webster Manufacturing Inc.?

<p>39% (A)</p> Signup and view all the answers

Interest income received by corporations is partially exempt from tax.

<p>False (B)</p> Signup and view all the answers

What is the average tax rate for Webster Manufacturing Inc. based on the provided information?

<p>32.3%</p> Signup and view all the answers

For corporations, __% of all dividend income received from investments in other corporations is excluded from taxation.

<p>70</p> Signup and view all the answers

Match the tax terms with their definitions:

<p>Marginal Tax Rate = Rate at which additional income is taxed Average Tax Rate = Total taxes divided by taxable income Tax-Deductible Expenses = Operating expenses and interest that can reduce taxable income Double Taxation = Corporate earnings taxed at both corporate and personal levels</p> Signup and view all the answers

Which of the following expenses can corporations deduct from their taxable income?

<p>Operating expenses (A)</p> Signup and view all the answers

If a corporation has no debt, it pays less in taxes than a similar company with debt due to tax-deductible interest expenses.

<p>False (B)</p> Signup and view all the answers

Calculate the tax for Webster Manufacturing Inc. if their before-tax earnings are $250,000.

<p>$80,750</p> Signup and view all the answers

Flashcards

Treasury Bills

Short-term debt securities issued by the government and traded in the money market. They are considered very safe investments.

Commercial Paper

Short-term debt securities issued by businesses, often used for short-term financing needs.

Negotiable Certificates of Deposit (CDs)

Short-term, interest-bearing deposits issued by financial institutions, commonly issued in denominations of $100,000 or more.

Eurocurrency Market

The international equivalent of the U.S. money market, dealing in short-term deposits in major currencies.

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Capital Market

A market where long-term debt and equity securities are traded, allowing businesses and governments to raise funds for long-term projects.

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Bonds

Long-term debt securities issued by companies or governments, usually with fixed interest payments and a maturity date.

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Common Stock

Units of ownership representing a portion of a company's value.

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Preferred Stock

A hybrid security with features of both bonds and common stock, offering fixed dividends and priority over common shares.

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Broker Market

A securities market where buyers and sellers are brought together to trade securities. These exchanges typically have centralized trading floors, such as the NYSE Euronext.

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Dealer Market

A market where buyers and sellers are not directly connected. Instead, securities dealers execute the transactions. There are no centralized trading floors; the transactions occur through a communications network.

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Spread

The difference between the price at which a dealer is willing to buy a security (bid price) and the price at which they are willing to sell it (ask price).

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Foreign Bonds

Bonds issued by foreign corporations or governments that are denominated in the investor's home currency and sold in the investor's home market.

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Eurobonds

Bonds issued by corporations or governments that are denominated in dollars and sold to investors outside the US.

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International Equity Market

A market that allows companies to sell shares to investors in multiple countries simultaneously.

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Largest Stock Market

Securities exchanges like the NYSE Euronext are ranked according to the total market value of securities listed.

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Second Largest Stock Market

Securities exchanges like the Tokyo Stock Exchange are ranked according to the total market value of securities listed.

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What is the role of capital markets for firms?

The role of capital markets from a firm's perspective is to provide a liquid market where they can raise funds by interacting with investors.

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What is the role of capital markets for investors?

The role of capital markets from an investor's perspective is to provide an efficient market where funds are allocated to the most productive uses.

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How does an efficient market work?

An efficient market allocates capital to its most profitable uses through competition among investors who seek to maximize their wealth. This competition also helps determine and publicize prices that are close to their true values.

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What is behavioral finance?

An emerging field that combines ideas from finance and psychology, behavioral finance suggests that prices of securities like stocks can deviate from their true value for extended periods.

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What are some examples of stock prices deviating from their true values?

The rapid rise and subsequent collapse of internet stock prices in the late 1990s and the failure of markets to accurately assess the risk of mortgage-backed securities in the recent financial crisis are examples of how stock prices sometimes deviate significantly from their true values.

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What is insider trading?

Insider trading involves using non-public information to gain an unfair advantage in the market. It is illegal and considered unethical.

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Why are insider trading laws important?

Insider trading laws were introduced in the 1930s to ensure all investors have access to the same information, creating a level playing field.

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Why do some argue that insider trading should be allowed?

Some argue that allowing insider trading could actually make markets more efficient, as the information revealed through insider trades would be valuable to other investors.

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Marginal Tax Rate

The rate at which an additional dollar of income is taxed.

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Average Tax Rate

The firm's total taxes divided by its taxable income.

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Ordinary Income

Income earned by a business from selling goods or services. It is taxed at the rates determined by the corporate tax rate schedule.

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Dividend Income

Income earned from owning shares of a corporation.

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Dividend Income Exclusion

70% of dividend income earned by a corporation from owning less than 20% of another corporation is excluded from taxation.

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Interest Income

Income earned from lending money to others.

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Tax-Deductible Expenses

Expenses that a business can deduct from its taxable income, reducing the amount of taxes it needs to pay.

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Tax Advantage of Debt Financing

The use of debt financing (borrowed money) allows a firm to benefit from tax deductions on interest payments, thus reducing their overall tax burden.

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Capital Gain

The difference between an asset's selling price and its original purchase price.

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Taxing Capital Gains for Corporations

For corporations, capital gains are treated as ordinary income and taxed at the company's regular tax rate.

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Tax Deductibility of Interest Expense

Debt financing allows businesses to deduct interest expense from their taxable income, effectively lowering their tax bill. This results in a lower after-tax cost of debt.

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Double Taxation of Dividends

Dividends paid to shareholders are not deductible for corporations, leading to double taxation. The company pays taxes on its profits, and then the shareholder pays taxes again on the dividends received.

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Role of Financial Institutions

Financial institutions play a key role in connecting savers (providers of funds) with borrowers (users of funds) through channels like loans and investments.

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Role of Financial Markets

Financial markets provide a platform for direct interaction between savers and borrowers. Examples include stock markets and bond markets.

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Money Market

The money market deals with short-term financial instruments like treasury bills and commercial paper. Savers and borrowers interact for short-term funding needs.

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The 2008 Financial Crisis

A financial crisis where banks lowered lending standards, invested heavily in risky mortgage-backed securities, and experienced massive losses due to declining home prices and rising mortgage delinquencies. This led to bank failures, credit restrictions, and a global recession.

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Glass-Steagall Act

A law which separated commercial banks (taking deposits and providing loans) from investment banks (dealing with securities and financial markets). It was designed to reduce risk and protect depositors.

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Gramm-Leach-Bliley Act

A law that repealed parts of the Glass-Steagall Act, allowing commercial and investment banks to merge. This created larger, more complex financial institutions.

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Securities Act of 1933

A law that regulates the sale of securities in the primary market, where new securities are issued.

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Securities Exchange Act of 1934

A law that regulates transactions in the secondary market where existing securities are traded. It also created the Securities and Exchange Commission (SEC).

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Corporate Income Tax

The income earned by corporations is subject to taxes. Corporate tax rates are applied to both ordinary income generated from business operations and capital gains from selling assets.

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Tax Deductions and Exclusions

Companies and individuals can reduce their tax obligations by utilizing specific tax code provisions. This includes deductions for expenses and exclusions for certain types of income like dividends.

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Study Notes

Chapter 2: The Financial Market Environment

  • This chapter focuses on the financial market environment including financial institutions and markets.
  • Learning Goals:
    • Understand financial institutions' role in managerial finance.
    • Contrast functions of financial institutions and markets.
    • Describe differences between capital markets and money markets.
    • Explain the 2008 financial crisis' causes and effects.
    • Understand major regulations affecting financial institutions and markets.
    • Discuss business taxes in financial decisions.
  • Firms can obtain funds from external sources through:
    • Financial institutions
    • Financial markets
    • Private placements
  • Financial institutions are intermediaries, channeling savings of individuals, businesses, and governments into loans or investments. Individuals are net suppliers of funds, while businesses and governments are net demanders.
  • Commercial banks provide savings accounts and loans. Investment banks assist with capital raising and major transactions like mergers. Shadow banking is a separate system of lending institutions that don't accept deposits, and are subject to fewer regulations. The Glass-Steagall Act was a 1933 law that separated commercial from investment banks but was repealed in 1999.
  • The U.S. banking industry is consolidating, with the number of commercial banks declining from 11,463 in 1992 to 6,048 in 2013.
  • Financial markets are forums for transactions between suppliers and demanders of funds directly. Transactions in short-term marketable securities occur in the money market, and long-term securities in the capital market. Private placement means selling securities to a specific investor, while most firms raise money through public offerings of bonds or stocks.
  • The primary market is where securities are initially issued, and secondary markets where pre-owned securities are traded.
  • The money market involves short-term marketable securities such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit. Eurocurrency markets, the international equivalent of domestic (U.S.) ones, are unregulated markets for short-term deposits.
  • The capital market involves long-term debt (bonds) and equity (common and preferred stock). Common stock represents ownership interest in a corporation. Preferred stock combines characteristics of bonds and common stock.
  • Examples of capital markets include the stock market, bond market.
  • House prices soared and then crashed between 1987 and 2006, causing a rise in mortgage delinquencies and foreclosures. This was a major factor in the 2008 financial crisis.
  • Bank stocks experienced a significant decline (81%) from 2008 to 2009.
  • Banks tightened lending standards, which reduced loan quantity during the crisis.

Regulatory Bodies & the Financial Sectors

  • The Glass-Steagall Act (1933) established the Federal Deposit Insurance Corporation (FDIC) providing bank deposit insurance.
  • The Act prohibited banks from certain activities to separate commercial and investment banking operations.
  • The Gramm-Leach-Bliley Act (1999) allowed business combinations, such as mergers, between commercial banks and others.
  • The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) aimed for improved regulation and consumer protection but is not yet fully implemented.
  • The Securities Act of 1933 regulates the sale of securities to the public.
  • The Securities Exchange Act of 1934 regulates transactions in the secondary market, including ongoing disclosures of publicly held companies, and limits insider trading.
  • The Securities and Exchange Commission (SEC) enforces federal laws governing the securities market.

Business Taxes

  • Individuals and businesses pay income taxes.
  • Sole proprietorships and partnerships are taxed as individual income, while corporations have their own corporate taxes.
  • Businesses earn ordinary income and capital gains.
  • Tax laws change frequently impacting ordinary income and capital gains.
  • Business taxes can impact financial decisions via the deductibility of interest and other expenses.
  • Dividend income is not deductible.
  • Capital gains are taxed based on the firm’s marginal tax rate.

Focus on Ethics and Practice

  • Insider trading involves using confidential information to profit in financial markets.
  • Laws prohibit insider trading in the U.S.

Integrative Case: Merit Enterprise Corp.

  • Merit Enterprise Corporation's CEO wants to expand production capacity by $4 billion in addition to their existing $2 billion.
  • Two options for raising capital are explored:
    • Option 1: Loan from banks. Likely to necessitate periodic financial disclosures.
    • Option 2: Issuing stock to the public. Would most likely command a high price, bringing in a suitable amount of capital.

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Chapter 2 The Financial Market Environment PDF

Description

Explore the intricate details of the financial market environment in Chapter 2. This chapter delves into the roles of financial institutions, the differences between capital and money markets, and the impact of the 2008 financial crisis. Additionally, it covers the regulations affecting these institutions and markets as well as considerations for business taxes in financial decisions.

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