The Financial Market Environment

Chapter 2
The Financial
Market
Environment
Learning Goals
LG1 Understand the role that financial institutions

play in managerial finance.
LG2 Contrast the functions of financial institutions and
financial markets.
LG3 Describe the differences between the capital
markets and the money markets.
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Learning Goals (cont.)
LG4 Explain the root causes and subsequent effects of

the 2008 financial crisis and recession.
LG5 Understand the major regulations and regulatory
bodies that affect financial institutions and
markets.
LG6 Discuss business taxes and their importance in
financial decisions.

Financial Institutions & Markets
Firms that require funds from external sources can

obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

Financial Institutions & Markets: Financial
Institutions
• Financial institutions are intermediaries that
channel the savings of individuals, businesses, and
governments into loans or investments.
• The key suppliers and demanders of funds are
individuals, businesses, and governments.
• In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.

Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that:
– provide savers with a secure place to invest their funds
– offer loans to individual and business borrowers
• Investment banks are institutions that:
– assist companies in raising capital
– advise firms on major transactions such as mergers or
financial restructurings
– engage in trading and market making activities

Commercial Banks, Investment Banks,
and the Shadow Banking System (cont.)
• The Glass-Steagall Act was an act of Congress in
1933 that created the federal deposit insurance
program and separated the activities of commercial
and investment banks. It was repealed it 1999 by
Congress.
• The shadow banking system describes a group of
institutions that:
– engage in lending activities, much like traditional banks
– but do not accept deposits
– are not subject to the same regulations as traditional
banks

Matter of Fact
• Consolidation in the U.S. Banking Industry:

– The U.S. banking industry has been going through a long
period of consolidation.
– According to the FDIC, the number of commercial banks in
the United States declined from 11,463 in 1992 to 6,048 in
2013, a decline of 47%.
– The decline is concentrated among small, community
banks, which larger institutions have been acquiring at a
rapid pace.

Markets
• Financial markets are forums in which suppliers
of funds and demanders of funds can transact
business directly.
• Transactions in short term marketable securities
take place in the money market while transactions
in long-term securities take place in the capital
market.
• A private placement involves the sale of a new
security directly to an investor or group of
investors.
• Most firms, however, raise money through a public
offering of securities, which is the sale of either
bonds or stocks to the general public.

Markets (cont.)
• The primary market is the financial market in
which securities are initially issued; the only market
in which the issuer is directly involved in the
transaction.
• Secondary markets are financial markets in which
preowned securities (those that are not new issues)
are traded.

Figure 2.1
Flow of Funds

The Money Market
• The money market is created by a financial

relationship between suppliers and demanders of
short-term funds.
• Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
• U.S. Treasury bills issues by the federal government
• commercial paper issued by businesses
• negotiable certificates of deposit issued by financial
institutions
• Investors generally consider marketable securities
to be among the least risky investments available.

The Money Market (cont.)
• The international equivalent of the domestic (U.S.)

money market is the Eurocurrency market.
• The Eurocurrency market is a market for short-term
bank deposits denominated in U.S. dollars or other
marketable currencies.
• The Eurocurrency market has grown rapidly mainly
because it is unregulated and because it meets the
needs of international borrowers and lenders.
• Nearly all Eurodollar deposits are time deposits.

The Capital Market
• The capital market is a market that enables

suppliers and demanders of long-term funds to
make transactions.
• The key capital market securities are bonds (long-
term debt) and both common and preferred stock
(equity, or ownership).
– Bonds are long-term debt instruments used by businesses
and government to raise large sums of money, generally
from a diverse group of lenders.
– Common stock are units of ownership interest or equity
in a corporation.
– Preferred stock is a special form of ownership that has
features of both a bond and common stock.

The Capital Market
Lakeview Industries, a major microprocessor

manufacturer, has issued a 9 percent coupon interest
rate, 20-year bond with a $1,000 par value that pays
interest semiannually.
– Investors who buy this bond receive the contractual right
to $90 annual interest (9% coupon interest rate  $1,000
par value) distributed as $45 at the end of each 6 months
(1/2  $90) for 20 years.
– Investors are also entitled to the $1,000 par value at the
end of year 20.

Focus on Practice
Berkshire Hathaway – Can Buffett Be Replaced?

– Since the early 1980s, Berkshire Hathaway’s Class A
common stock price has climbed from $285/share to
$114,000/share.
– The company is led by Chairman Warren Buffett (83) and
Vice-Chairman Charlie Munger (89).
– 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?

Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which
the two sides of a transaction, the buyer and seller,
are brought together to trade securities.
– Trading takes place on centralized trading floors of national
exchanges, such as NYSE Euronext, as well as regional
exchanges.

Broker Markets and
Dealer Markets (cont.)
• Dealer markets, such as Nasdaq, are markets in
which the buyer and seller are not brought together
directly but instead have their orders executed by
securities dealers that “make markets” in the given
security.
– The dealer market has no centralized trading floors.
Instead, it is made up of a large number of market makers
who are linked together via a mass-telecommunications
network.
• As compensation for executing orders, market
makers make money on the spread (bid price – ask
price).

Matter of Fact
According to the World Federation of Exchanges, in

2012:
1. NYSE Euronext is the largest stock market in the world, as
measured by the total market value of securities listed on
that market. NYSE Euronext has listed securities worth
more than $14.1 trillion in the U.S. and $2.1 trillion in
Europe.
2. The second largest exchange is Nasdaq, with listed
securities valued at $4.6 trillion.
3. The Tokyo Stock Exchange has securities valued at $3.5
trillion.
4. The fourth largest exchange, the London Stock Exchange,
has securities valued at $3.3 trillion.

International Capital Markets
• In the Eurobond market, corporations and

governments typically issue bonds denominated in
dollars and sell them to investors located outside
the United States.
• The foreign bond market is a market for bonds
issued by a foreign corporation or government that
is denominated in the investor’s home currency and
sold in the investor’s home market.
• The international equity market allows
corporations to sell blocks of shares to investors in
a number of different countries simultaneously.

The Role of Capital Markets
• From a firm’s perspective, the role of capital

markets is to be a liquid market where firms can
interact with investors in order to obtain valuable
external financing resources.
• From investors’ perspectives, the role of capital
markets is to be an efficient market that allocates
funds to their most productive uses.
• An efficient market allocates funds to their most
productive uses as a result of competition among
wealth-maximizing investors and determines and
publicizes prices that are believed to be close to
their true value.

The Role of Capital Markets (cont.)
• Advocates of behavioral finance, an emerging

field that blends ideas from finance and psychology,
argue that stock prices and prices of other
securities can deviate from their true values for
extended periods.
• Examples of the principle that stock prices
sometimes can be wildly inaccurate measures of
value include:
• the huge run up and subsequent collapse of the prices of
Internet stocks in the late 1990s
• the failure of markets to accurately assess the risk of
mortgage-backed securities in the more recent financial
crisis

Focus on Ethics
• The Ethics of Insider Trading

– Bryan Shaw received inside information on Herbalife and
Skechers from Scott London, a KPMG auditor. Using this
information, Shaw made $1.3 million in trading profits. He
pleaded guilty to insider trading charges in 2013.
– Laws prohibiting insider trading were established in the United
States in the 1930s. These laws are designed to ensure that all
investors have access to relevant information on the same terms.
– Some market participants believe that insider trading should be
permitted, arguing that information about the trades of insiders
would be useful information to the market.
• If efficiency is the goal of financial markets, is allowing or
disallowing insider trading more unethical?
• Does allowing insider trading create an ethical dilemma for
insiders?

The Financial Crisis: Financial Institutions
and Real Estate Finance
• Securitization is the process of pooling mortgages
or other types of loans and then selling claims or
securities against that pool in a secondary market.
• Mortgage-backed securities represent claims on
the cash flows generated by a pool of mortgages
and can be purchased by individual investors,
pension funds, mutual funds, or virtually any other
investor.
• A primary risk associated with mortgage-back
securities is that homeowners may not be able to,
or may choose not to, repay their loans.

The Financial Crisis: Falling Home Prices
and Delinquent Mortgages
• Rising home prices between 1987 and 2006 kept
mortgage default rate low.
• Lenders relaxed standards for borrowers and
created subprime mortgages.
• As housing prices fell from 2006 to 2009, many
borrowers had trouble making payments, but were
unable to refinance.
• As a result, there was a sharp increase in the
number of delinquencies and foreclosures.

The Financial Crisis: Falling Home Prices
and Delinquent Mortgages
Figure 2.2 House Prices Soar and then Crash

The Financial Crisis: Crisis of Confidence
in Banks
The price of bank stocks fell 81% between January

2008 and March 2009.

The Financial Crisis: Crisis of Confidence
in Banks
Figure 2.3 Bank Stocks Plummet During Financial Crisis

The Financial Crisis: Spillover Effects and
the Great Recession
• As banks came under intense financial pressure in
2008, they tightened their lending standards and
dramatically reduced the quantity of loans they
made.
• Corporations found that they could no longer raise
money in the money market, or could only do so at
extraordinarily high rates.
• As a consequence, businesses began to hoard cash
and cut back on expenditures, and economic
activity contracted.

Regulation of Financial Institutions and Markets:
Regulations Governing Financial Institutions
• The Glass-Steagall Act (1933) established the

Federal Deposit Insurance Corporation (FDIC)
which provides insurance for deposits at banks and
monitors banks to ensure their safety and
soundness.
• The Glass-Steagall Act also prohibited institutions
that took deposits from engaging in activities such
as securities underwriting and trading, thereby
effectively separating commercial banks from
investment banks.

Regulations Governing Financial Institutions
• The Gramm-Leach-Bliley Act (1999) allows

business combinations (e.g. mergers) between
commercial banks, investment banks, and
insurance companies, and thus permits these
institutions to compete in markets that prior
regulations prohibited them from entering.
• Congress passed the Dodd-Frank Wall Street
Reform and Consumer Protection Act in 2010, but it
has not been fully implemented.

Regulations Governing Financial Markets
• The Securities Act of 1933 regulates the sale of

securities to the public via the primary market.
– Requires sellers of new securities to provide extensive
disclosures to the potential buyers of those securities.
• The Securities Exchange Act of 1934 regulates
the trading of securities such as stocks and bonds
in the secondary market.
– Created the Securities Exchange Commission, which is
the primary government agency responsible for enforcing
federal securities laws.
– Requires ongoing disclosure by companies whose securities
trade in secondary markets (e.g., 10-Q, 10-K).
– Imposes limits on the extent to which “insiders” can trade
in their firm’s securities.

Business Taxes
• Both individuals and businesses must pay taxes on

income.
• The income of sole proprietorships and partnerships
is taxed as the income of the individual owners,
whereas corporate income is subject to corporate
taxes.
• Both individuals and businesses can earn two types
of income—ordinary income and capital gains
income.
• Under current law, tax treatment of ordinary
income and capital gains income change frequently
due frequently changing tax laws.

Table 2.1
Corporate Tax Rate Schedule

Business Taxes:
Ordinary Income
• Ordinary income is earned through the sale of a
firm’s goods or services and is taxed at the rates
depicted in Table 2.1 on the previous slide.
Example
Webster Manufacturing Inc. has before-tax earnings of $250,000.
Tax = $22,500 + [0.39  ($250,000 – $100,000)]
Tax = $22,500 + (0.39  $150,000)
Tax = $22,500 + $58,500 = $80,750

Business Taxation: Marginal versus
Average Tax Rates
• A firm’s marginal tax rate represents the rate at
which additional income is taxed.
• The average tax rate is the firm’s taxes divided by
taxable income.
Example
What are Webster Manufacturing’s marginal and average tax rates?
Marginal Tax Rate = 39%
Average Tax Rate = $80,750/$250,000 = 32.3%

Business Taxation:
Interest and Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion moderates the effect of double
taxation, which occurs when after-tax corporate
earnings are distributed as cash dividends to
stockholders, who then must pay personal taxes on
the dividend amount.
• Unlike dividend income, all interest income received
is fully taxed.

Business Taxation:
Tax-Deductible Expenses
• In calculating taxes, corporations may deduct
operating expenses and interest expense but not
dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will
demonstrate.
Example
Two companies, Debt Co. and No Debt Co., both expect in
the coming year to have EBIT of $200,000. During the
year, Debt Co. will have to pay $30,000 in interest
expenses. No Debt Co. has no debt and will pay not
interest expenses.

Business Taxation:
Tax-Deductible Expenses (cont.)

Business Taxation:
Tax-Deductible Expenses (cont.)
• As the example shows, the use of debt financing
can increase cash flow and EPS, and decrease taxes
paid.
• The tax deductibility of interest and other certain
expenses reduces their actual (after-tax) cost to the
profitable firm.
• It is the non-deductibility of dividends paid that
results in double taxation under the corporate form
of organization.

Business Taxation: Capital Gains
• A capital gain is the amount by which the sale

price of an asset exceeds the asset’s purchase
price.
• For corporations, capital gains are added to
ordinary income and taxed like ordinary income at
the firm’s marginal tax rate.
Example
Ross Company has just sold for $150,000 and asset that
was purchased 2 years ago for $125,000. Because the
asset was sold for more than its initial purchase price,
there is a capital gain of $25,000 ($150,000 - $125,000).

Review of Learning Goals
LG1 Understand the role that financial institutions

play in managerial finance.
Financial institutions bring net suppliers of funds and net
demanders together to help translate the savings of
individuals, businesses, and governments into loans and
other types of investments.
LG2 Contrast the functions of financial institutions and
financial markets.
Financial institutions collect the savings of individuals and
channel those funds to borrowers such as businesses and
governments. Financial markets provide a forum in which
savers and borrowers can transact business directly.

Review of Learning Goals (cont.)
LG3 Describe the differences between the capital markets

and the money markets.
In the money market, savers who want a temporary place to
deposit funds where they can earn interest interact with
borrowers who have a short-term need for funds. In contrast,
the capital market is the forum in which savers and borrowers
interact on a long-term basis.
LG4 Explain the root causes and subsequent effects of the
2008 financial crisis and recession.
Financial institutions lowered their standards for lending to
prospective homeowners and invested heavily in mortgage-
backed securities. When home prices fell and mortgage
delinquencies rose, the value of the mortgage-backed securities
held by banks plummeted, causing some banks to fail and many
others to restrict the flow of credit to business. That contributed
to a severe recession in the United States and abroad.

LG5 Understand the major regulations and regulatory bodies

that affect financial institutions and markets.
The Glass-Steagall Act created the FDIC and imposed a separation
between commercial and investment banks. The Act was designed
to limit the risks that banks could take and to protect depositors.
Recently, the Gramm-Leach-Bliley Act essentially repealed the
elements of Glass-Steagall pertaining to the separation of
commercial and investment banks. After the recent financial crisis,
much debate has occurred regarding the proper regulation of large
financial institutions.
The Securities Act of 1933 focuses on regulating the sale of
securities in the primary market, whereas the Securities Exchange
Act of 1934 deals with regulations governing transactions in the
secondary market. The 1934 Act also created the Securities and
Exchange Commission, the primary body responsible for enforcing
federal securities laws.

LG6 Discuss business taxes and their importance in

financial decisions.
Corporate income is subject to corporate taxes. Corporate
tax rates apply to both ordinary income (after deduction of
allowable expenses) and capital gains. The average tax
rate paid by a corporation ranges from 15 to 35 percent.
Corporate taxpayers can reduce their taxes through certain
provisions in the tax code: dividend income exclusions and
tax-deductible expenses. A capital gain occurs when an
asset is sold for more than its initial purchase price; they
are added to ordinary corporate income and taxed at
regular corporate tax rates.

Chapter Resources on MyFinanceLab
• Chapter Cases
• Group Exercises
• Critical Thinking Problems

Integrative Case: Merit Enterprise Corp.
Merit Enterprise Corporation’s CEO would like to

dramatically expand the company’s production
capacity. This would require the company to raise up
to $4 billion in addition to the $2 billion of excess cash
that they have accumulated. Merit is currently a
private company and is considering two options for
raising the much needed capital.

Option 1 – Merit could approach JPMorgan Chase, a

bank that had served Merit well for many years with
seasonal credit lines as well as medium-term loans.
Lehn believed that JPMorgan was unlikely to make
a $4 billion loan to Merit on its own, but it could
probably gather a group of banks together to make
a loan of this magnitude. However, the banks would
undoubtedly demand that Merit limit further
borrowing and provide JPMorgan with periodic
financial disclosures so that they could monitor
Merit’s financial condition as it expanded its
operations.

Option 2 – Merit could convert to public ownership,

issuing stock to the public in the primary market.
With Merit’s excellent financial performance in
recent years, Sara thought that its stock could
command a high price in the market and that many
investors would want to participate in any stock
offering that Merit conducted.

a. Discuss the pros and cons of option 1, and

prioritize your thoughts. What are the most
positive aspects of this option, and what are the
biggest drawbacks?
b. Do the same for option 2.
c. Which option do you think Sara should recommend
to the board and why?

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Chapter 2

LG1 Understand the role that financial institutions

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LG4 Explain the root causes and subsequent effects of

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Firms that require funds from external sources can

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• Consolidation in the U.S. Banking Industry:

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• The money market is created by a financial

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• The international equivalent of the domestic (U.S.)

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• The capital market is a market that enables

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Lakeview Industries, a major microprocessor

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Berkshire Hathaway – Can Buffett Be Replaced?

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According to the World Federation of Exchanges, in

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• In the Eurobond market, corporations and

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• From a firm’s perspective, the role of capital

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• Advocates of behavioral finance, an emerging

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• The Ethics of Insider Trading

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Figure 2.2 House Prices Soar and then Crash

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The price of bank stocks fell 81% between January

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• The Glass-Steagall Act (1933) established the

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• The Gramm-Leach-Bliley Act (1999) allows

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• The Securities Act of 1933 regulates the sale of

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• Both individuals and businesses must pay taxes on

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