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Fundamentals of Financial Management.

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The document provides an overview of key concepts related to business organizations, taxation, and financial markets. It discusses the four main forms of business organization in the US - sole proprietorships, partnerships, corporations, and limited liability companies. It also covers corporate income tax calculation, various depreciation methods like straight-line and MACRS, and how the Jobs and Growth Tax Relief Reconciliation Act of 2003 temporarily increased bonus depreciation deductions. The goal is for readers to understand these important business, tax, and financial environments.

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Chapter 2 The Business, Tax, and Financial Environments © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI 1
After studying Chapter 2, you should be able to: 1. Describe the four basic forms of business organization in the United States -- and the advantages and disadvantages of each. 2. Understand how to calculate a corporation's taxable income and how to determine the corporate tax rate - both average and marginal. 3. Understand various methods of depreciation. 4. Understand why acquiring assets through the use of debt financing offers a tax advantage over both common and preferred stock financing. 5. Describe the purpose and make up of financial markets. 6. Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a security’s default risk. 7. Understand what is meant by the term “term structure of interest rates” and relate it to a “yield curve.” 2
The Business, Tax, and Financial Environments The Business Environment The Tax Environment The Financial Environment 3
The Business Environment The U.S. has four basic forms of business organization: Sole Proprietorships Partnerships (general and limited) Corporations Limited liability companies 4
The Business Environment Sole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm. Oldest form of business organization. Business income is accounted for on your personal income tax form. form 5
Summary for Sole Proprietorship Advantages Disadvantages Simplicity Unlimited liability Low setup cost Hard to raise additional capital Quick setup Transfer of Single tax filing ownership on individual form difficulties 6
The Business Environment Partnership -- A business form in which two or more individuals act as owners. Business income is accounted for on each partner’s personal income tax form. form 7
Types of Partnerships General Partnership -- all partners have unlimited liability and are liable for all obligations of the partnership. Limited Partnership -- limited partners have liability limited to their capital contribution (investors only). At least one general partner is required and all general partners have unlimited liability. 8
Summary for Partnership Advantages Disadvantages Can be simple Unlimited liability for the general partner Low setup cost, higher than sole Difficult to raise proprietorship additional capital, but easier than sole Relatively quick setup proprietorship Limited liability for limited partners Transfer of ownership difficulties 9
The Business Environment Corporation -- A business form legally separate from its owners. An artificial entity that can own assets and incur liabilities. Business income is accounted for on the income tax form of the corporation. corporation 10
Summary for Corporation Advantages Disadvantages Limited liability Double taxation Easy transfer of More difficult to ownership establish Unlimited life More expensive to set up and Easier to raise large maintain quantities of capital 11
The Business Environment Limited Liability Companies -- A business form that provides its owners (called “members”) with corporate- style limited personal liability and the federal-tax treatment of a partnership. Business income is accounted for on each “member’s” individual income tax form. form 12
Limited Liability Company (LLC) Generally, an LLC will possess only the first two of the following four standard corporation characteristics Limited liability Centralized management Unlimited life Transfer of ownership without other owners’ prior consent 13
Summary for LLC Advantages Disadvantages Limited liability Limited life (generally) Eliminates double taxation Transfer of ownership No restriction on difficulties number or type of (generally) owners Easier to raise 14 additional capital
Corporate Income Taxes Corp. Taxable Income Tax At Least But < Rate Tax Calculation $ 0 $ 50,000 15% .15x(Inc > 0) 50,000 75,000 25% $ 7,500 + .25x(Inc > 50,000) 75,000 100,000 34% 13,750 + .34x(Inc > 75,000) 100,000 335,000 39% 22,250 + .39x(Inc > 100,000) 335,000 10,000,000 34% 113,900 + .34x(Inc > 335,000) 10,000,000 15,000,000 35% 3,400,000 + .35x(Inc > 10,000,000) 15,000,000 18,333,333 38% 5,150,000 + .38x(Inc > 15,000,000) 18,333,333 35% 6,416,667 + .35x(Inc > 18,333,333) 15
Income Tax Example Lisa Miller of Basket Wonders (BW) is calculating the income tax liability, marginal tax rate, and liability rate average tax rate for the fiscal year ending December 31. BW’s corporate taxable income for this fiscal year was $250,000. 16
Income Tax Example Income tax liability = $22,250 + .39 x ($250,000 - $100,000) $100,000 = $22,250 + $58,500 = $80,750 Marginal tax rate = 39% Average tax rate = $80,750 / $250,000 = 32.3% 17
Depreciation Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Generally, profitable firms prefer to use an accelerated method for tax reporting purposes. 18
Common Types of Depreciation Straight-line (SL) Accelerated Types Double Declining Balance (DDB) Modified Accelerated Cost Recovery System (MACRS) 19
Depreciation Example Lisa Miller of Basket Wonders (BW) is calculating the depreciation on a machine with a depreciable basis of $100,000, a 6- year useful life, and a 5-year property life class life. She calculates the annual depreciation charges using MACRS. [Note – ignore “bonus” depreciation discussed in 2-25] 20
MACRS Example Assets are depreciated based on one of eight different property classes. Generally, the half-year convention is used. Depreciation in any particular year is the maximum of DDB or straight-line. A switch in depreciation methods is made from DDB to SL during the life 21 of the asset.
MACRS Example Depreciation Depreciation Net Book Year Calculation Charge Value 0 --- --- $100,000 1 .5X2X(1/5) X $100,000 $ 20,000 80,000 2 2 X ( 1 / 5) X $80,000 32,000 48,000 3 2 X ( 1 / 5) X $48,000 19,200 28,800 4 $28,800 / 2.5 Years 11,520 17,280 5 $28,800 / 2.5 Years 11,520 5,760 6 $28,800 / 2.5 Yrs X .5 5,760 0 22
MACRS Schedule Recovery Property Class Year 3-Year 5-Year 7-Year 1 33.33% 20.00% 14.29% 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46 23
Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & Extension of Bonus Depreciation • Increases a limited and additional temporary depreciation deduction of 50% in the first year -- subject to stipulations. • Designed to enhance capital investment by businesses. 24
Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & Extension of Bonus Depreciation • Example: Example • $200,000 machine under 5-year MACRS property class. Bonus = 50% of $200K = $100K. • Remaining $100K ($200K - $100K bonus) at 20% rate based on MACRS is $20K. • Result is $120K ($100K + $20K) depreciation charge in the first year. • Set to expire soon, so will ignore in subsequent 25 problems (note – ignored in slide 2-20)
Other Tax Issues Alternative Minimum Tax is a special tax which equals 20% of alternative minimum taxable income (generally not equal to taxable income). Corporations pay the maximum of AMT or regular tax liability. Quarterly Tax Payments require corporations to pay 25% of their estimated annual tax liability on the 15th of April, June, September, and December. 26
Interest Deductibility Interest Expense is the interest paid on outstanding debt and is tax deductible. deductible Cash Dividend is the cash distribution of earnings to shareholders and is not a tax deductible expense. The after-tax cost of debt is: (Interest Expense) X ( 1 - Tax Rate) Thus, debt financing has a tax advantage! advantage 27
Handling Corporate Losses and Gains Corporations that sustain a net operating loss can carry that loss back (Carryback) 2 years and forward (Carryforward) 20 years to offset Carryforward operating gains in those years. Losses are generally carried back first and then forward starting with the earliest year with operating gains. 28
Corporate Losses and Gains Example Lisa Miller is examining the impact of an operating loss at Basket Wonders (BW) in 2003. The following time line shows operating income and losses. What impact does the 2007 loss have on BW? 2004 2005 2006 2007 $150,000 $150,000 $100,000 -$500,000 29
Corporate Losses and Gains Example The loss can offset the gain in each of the years 2005 and 2006. The remaining $250,000 can be carried forward to 2008 or beyond. Impact: Tax refund for federal taxes paid in 2005 and 2006. 2004 2005 2006 2007 $150,000 $150,000 $100,000 -$500,000 -$150,000 -$100,000 $250,000 $150,000 0 0 -$250,000 30
Corporate Capital Gains / Losses Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells for more than original cost) or capital loss (asset sells for less than original cost). Often historically, capital gains income has received more favorable U.S. tax treatment than operating income. 31
Corporate Capital Gains / Losses Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%. Capital losses are deductible only against capital gains. gains 32
Personal Income Taxes The U.S. has a progressive tax structure with four tax brackets of 10%, 15%, 25%, 28%, 33%, and 35%. 15% 28% 33% 35% Personal income taxes are determined by taxable income, filing status, and various credits. Result is that low income individuals pay no federal tax and others may 33 fluctuate between the marginal rates.
Financial Environment Businesses interact continually with the financial markets. Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together. The purpose of financial markets is to efficiently allocate savings to ultimate 34 users.
Flow of Funds in the Economy INVESTMENT SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS SECONDARY MARKET SAVINGS SECTOR 35
Flow of Funds in the Economy INVESTMENT SECTOR INVESTMENT SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Businesses SECONDARY MARKET Government Households SAVINGS SECTOR 36
Flow of Funds in the Economy INVESTMENT SECTOR SAVINGS SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Households SECONDARY MARKET Businesses Government SAVINGS SECTOR 37
Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL BROKERS INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Investment Bankers SECONDARY MARKET Mortgage Bankers SAVINGS SECTOR 38
Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL INTERMEDIARIES INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Commercial Banks Savings Institutions SECONDARY MARKET Insurance Cos. Pension Funds Finance Companies SAVINGS SECTOR Mutual Funds 39
Flow of Funds in the Economy INVESTMENT SECTOR SECONDARY MARKET INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Security Exchanges SECONDARY MARKET OTC Market SAVINGS SECTOR 40
Allocation of Funds Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant). In a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities. Result: Savings tend to be allocated to the most efficient uses. 41
Risk-Expected Return Profile Speculative Common Stocks EXPECTED RETURN (%) Conservative Common Stocks Preferred Stocks Medium-grade Corporate Bonds Investment-grade Corporate Bonds Long-term Government Bonds Prime-grade Commercial Paper U.S. Treasury Bills (risk-free securities) RISK 42
What Influences Security Expected Returns? Default Risk is the failure to meet the terms of a contract. Marketability is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession. 43
Ratings by Investment Agencies on Default Risk MOODY’S INV SERVICE STANDARD & POOR’S Aaa Best Quality AAA Highest Grade Aa High Quality AA High Grade A Upper Med Grade A Higher Med Grade Baa Medium Grade BBB Medium Grade Ba Possess Speculative BB Speculative Elements C Lowest Grade D In Default Investment grade represents the top four categories. Below investment grade represents all other categories. 44
What Influences Expected Security Returns? Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due. Taxability considers the expected tax consequences of the security. 45
Term Structure of Interest Rates Upward Sloping Yield Curve 0 2 4 6 8 10 (Usual) YIELD (%) Downward Sloping Yield Curve (Unusual) 0 5 10 15 20 25 30 YEARS TO MATURITY A yield curve is a graph of the relationship between yields and term to maturity for particular securities. 46
What Influences Expected Security Returns? Embedded Options provide the opportunity to change specific attributes of the security. Inflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return. 47

More Related Content

Fundamentals of Financial Management.

  • 1. Chapter 2 The Business, Tax, and Financial Environments © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI 1
  • 2. After studying Chapter 2, you should be able to: 1. Describe the four basic forms of business organization in the United States -- and the advantages and disadvantages of each. 2. Understand how to calculate a corporation's taxable income and how to determine the corporate tax rate - both average and marginal. 3. Understand various methods of depreciation. 4. Understand why acquiring assets through the use of debt financing offers a tax advantage over both common and preferred stock financing. 5. Describe the purpose and make up of financial markets. 6. Demonstrate an understanding of how letter ratings of the major rating agencies help you to judge a security’s default risk. 7. Understand what is meant by the term “term structure of interest rates” and relate it to a “yield curve.” 2
  • 3. The Business, Tax, and Financial Environments The Business Environment The Tax Environment The Financial Environment 3
  • 4. The Business Environment The U.S. has four basic forms of business organization: Sole Proprietorships Partnerships (general and limited) Corporations Limited liability companies 4
  • 5. The Business Environment Sole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm. Oldest form of business organization. Business income is accounted for on your personal income tax form. form 5
  • 6. Summary for Sole Proprietorship Advantages Disadvantages Simplicity Unlimited liability Low setup cost Hard to raise additional capital Quick setup Transfer of Single tax filing ownership on individual form difficulties 6
  • 7. The Business Environment Partnership -- A business form in which two or more individuals act as owners. Business income is accounted for on each partner’s personal income tax form. form 7
  • 8. Types of Partnerships General Partnership -- all partners have unlimited liability and are liable for all obligations of the partnership. Limited Partnership -- limited partners have liability limited to their capital contribution (investors only). At least one general partner is required and all general partners have unlimited liability. 8
  • 9. Summary for Partnership Advantages Disadvantages Can be simple Unlimited liability for the general partner Low setup cost, higher than sole Difficult to raise proprietorship additional capital, but easier than sole Relatively quick setup proprietorship Limited liability for limited partners Transfer of ownership difficulties 9
  • 10. The Business Environment Corporation -- A business form legally separate from its owners. An artificial entity that can own assets and incur liabilities. Business income is accounted for on the income tax form of the corporation. corporation 10
  • 11. Summary for Corporation Advantages Disadvantages Limited liability Double taxation Easy transfer of More difficult to ownership establish Unlimited life More expensive to set up and Easier to raise large maintain quantities of capital 11
  • 12. The Business Environment Limited Liability Companies -- A business form that provides its owners (called “members”) with corporate- style limited personal liability and the federal-tax treatment of a partnership. Business income is accounted for on each “member’s” individual income tax form. form 12
  • 13. Limited Liability Company (LLC) Generally, an LLC will possess only the first two of the following four standard corporation characteristics Limited liability Centralized management Unlimited life Transfer of ownership without other owners’ prior consent 13
  • 14. Summary for LLC Advantages Disadvantages Limited liability Limited life (generally) Eliminates double taxation Transfer of ownership No restriction on difficulties number or type of (generally) owners Easier to raise 14 additional capital
  • 15. Corporate Income Taxes Corp. Taxable Income Tax At Least But < Rate Tax Calculation $ 0 $ 50,000 15% .15x(Inc > 0) 50,000 75,000 25% $ 7,500 + .25x(Inc > 50,000) 75,000 100,000 34% 13,750 + .34x(Inc > 75,000) 100,000 335,000 39% 22,250 + .39x(Inc > 100,000) 335,000 10,000,000 34% 113,900 + .34x(Inc > 335,000) 10,000,000 15,000,000 35% 3,400,000 + .35x(Inc > 10,000,000) 15,000,000 18,333,333 38% 5,150,000 + .38x(Inc > 15,000,000) 18,333,333 35% 6,416,667 + .35x(Inc > 18,333,333) 15
  • 16. Income Tax Example Lisa Miller of Basket Wonders (BW) is calculating the income tax liability, marginal tax rate, and liability rate average tax rate for the fiscal year ending December 31. BW’s corporate taxable income for this fiscal year was $250,000. 16
  • 17. Income Tax Example Income tax liability = $22,250 + .39 x ($250,000 - $100,000) $100,000 = $22,250 + $58,500 = $80,750 Marginal tax rate = 39% Average tax rate = $80,750 / $250,000 = 32.3% 17
  • 18. Depreciation Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Generally, profitable firms prefer to use an accelerated method for tax reporting purposes. 18
  • 19. Common Types of Depreciation Straight-line (SL) Accelerated Types Double Declining Balance (DDB) Modified Accelerated Cost Recovery System (MACRS) 19
  • 20. Depreciation Example Lisa Miller of Basket Wonders (BW) is calculating the depreciation on a machine with a depreciable basis of $100,000, a 6- year useful life, and a 5-year property life class life. She calculates the annual depreciation charges using MACRS. [Note – ignore “bonus” depreciation discussed in 2-25] 20
  • 21. MACRS Example Assets are depreciated based on one of eight different property classes. Generally, the half-year convention is used. Depreciation in any particular year is the maximum of DDB or straight-line. A switch in depreciation methods is made from DDB to SL during the life 21 of the asset.
  • 22. MACRS Example Depreciation Depreciation Net Book Year Calculation Charge Value 0 --- --- $100,000 1 .5X2X(1/5) X $100,000 $ 20,000 80,000 2 2 X ( 1 / 5) X $80,000 32,000 48,000 3 2 X ( 1 / 5) X $48,000 19,200 28,800 4 $28,800 / 2.5 Years 11,520 17,280 5 $28,800 / 2.5 Years 11,520 5,760 6 $28,800 / 2.5 Yrs X .5 5,760 0 22
  • 23. MACRS Schedule Recovery Property Class Year 3-Year 5-Year 7-Year 1 33.33% 20.00% 14.29% 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46 23
  • 24. Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & Extension of Bonus Depreciation • Increases a limited and additional temporary depreciation deduction of 50% in the first year -- subject to stipulations. • Designed to enhance capital investment by businesses. 24
  • 25. Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & Extension of Bonus Depreciation • Example: Example • $200,000 machine under 5-year MACRS property class. Bonus = 50% of $200K = $100K. • Remaining $100K ($200K - $100K bonus) at 20% rate based on MACRS is $20K. • Result is $120K ($100K + $20K) depreciation charge in the first year. • Set to expire soon, so will ignore in subsequent 25 problems (note – ignored in slide 2-20)
  • 26. Other Tax Issues Alternative Minimum Tax is a special tax which equals 20% of alternative minimum taxable income (generally not equal to taxable income). Corporations pay the maximum of AMT or regular tax liability. Quarterly Tax Payments require corporations to pay 25% of their estimated annual tax liability on the 15th of April, June, September, and December. 26
  • 27. Interest Deductibility Interest Expense is the interest paid on outstanding debt and is tax deductible. deductible Cash Dividend is the cash distribution of earnings to shareholders and is not a tax deductible expense. The after-tax cost of debt is: (Interest Expense) X ( 1 - Tax Rate) Thus, debt financing has a tax advantage! advantage 27
  • 28. Handling Corporate Losses and Gains Corporations that sustain a net operating loss can carry that loss back (Carryback) 2 years and forward (Carryforward) 20 years to offset Carryforward operating gains in those years. Losses are generally carried back first and then forward starting with the earliest year with operating gains. 28
  • 29. Corporate Losses and Gains Example Lisa Miller is examining the impact of an operating loss at Basket Wonders (BW) in 2003. The following time line shows operating income and losses. What impact does the 2007 loss have on BW? 2004 2005 2006 2007 $150,000 $150,000 $100,000 -$500,000 29
  • 30. Corporate Losses and Gains Example The loss can offset the gain in each of the years 2005 and 2006. The remaining $250,000 can be carried forward to 2008 or beyond. Impact: Tax refund for federal taxes paid in 2005 and 2006. 2004 2005 2006 2007 $150,000 $150,000 $100,000 -$500,000 -$150,000 -$100,000 $250,000 $150,000 0 0 -$250,000 30
  • 31. Corporate Capital Gains / Losses Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells for more than original cost) or capital loss (asset sells for less than original cost). Often historically, capital gains income has received more favorable U.S. tax treatment than operating income. 31
  • 32. Corporate Capital Gains / Losses Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%. Capital losses are deductible only against capital gains. gains 32
  • 33. Personal Income Taxes The U.S. has a progressive tax structure with four tax brackets of 10%, 15%, 25%, 28%, 33%, and 35%. 15% 28% 33% 35% Personal income taxes are determined by taxable income, filing status, and various credits. Result is that low income individuals pay no federal tax and others may 33 fluctuate between the marginal rates.
  • 34. Financial Environment Businesses interact continually with the financial markets. Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together. The purpose of financial markets is to efficiently allocate savings to ultimate 34 users.
  • 35. Flow of Funds in the Economy INVESTMENT SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS SECONDARY MARKET SAVINGS SECTOR 35
  • 36. Flow of Funds in the Economy INVESTMENT SECTOR INVESTMENT SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Businesses SECONDARY MARKET Government Households SAVINGS SECTOR 36
  • 37. Flow of Funds in the Economy INVESTMENT SECTOR SAVINGS SECTOR INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Households SECONDARY MARKET Businesses Government SAVINGS SECTOR 37
  • 38. Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL BROKERS INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Investment Bankers SECONDARY MARKET Mortgage Bankers SAVINGS SECTOR 38
  • 39. Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL INTERMEDIARIES INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Commercial Banks Savings Institutions SECONDARY MARKET Insurance Cos. Pension Funds Finance Companies SAVINGS SECTOR Mutual Funds 39
  • 40. Flow of Funds in the Economy INVESTMENT SECTOR SECONDARY MARKET INTERMEDIARIES FINANCIAL FINANCIAL BROKERS Security Exchanges SECONDARY MARKET OTC Market SAVINGS SECTOR 40
  • 41. Allocation of Funds Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant). In a rational world, the highest expected returns will be offered only by those economic units with the most promising investment opportunities. Result: Savings tend to be allocated to the most efficient uses. 41
  • 42. Risk-Expected Return Profile Speculative Common Stocks EXPECTED RETURN (%) Conservative Common Stocks Preferred Stocks Medium-grade Corporate Bonds Investment-grade Corporate Bonds Long-term Government Bonds Prime-grade Commercial Paper U.S. Treasury Bills (risk-free securities) RISK 42
  • 43. What Influences Security Expected Returns? Default Risk is the failure to meet the terms of a contract. Marketability is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession. 43
  • 44. Ratings by Investment Agencies on Default Risk MOODY’S INV SERVICE STANDARD & POOR’S Aaa Best Quality AAA Highest Grade Aa High Quality AA High Grade A Upper Med Grade A Higher Med Grade Baa Medium Grade BBB Medium Grade Ba Possess Speculative BB Speculative Elements C Lowest Grade D In Default Investment grade represents the top four categories. Below investment grade represents all other categories. 44
  • 45. What Influences Expected Security Returns? Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due. Taxability considers the expected tax consequences of the security. 45
  • 46. Term Structure of Interest Rates Upward Sloping Yield Curve 0 2 4 6 8 10 (Usual) YIELD (%) Downward Sloping Yield Curve (Unusual) 0 5 10 15 20 25 30 YEARS TO MATURITY A yield curve is a graph of the relationship between yields and term to maturity for particular securities. 46
  • 47. What Influences Expected Security Returns? Embedded Options provide the opportunity to change specific attributes of the security. Inflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return. 47