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2-1
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
2-2
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
2-4
The Business
Environment
 Sole Proprietorships
 Partnerships (general and limited)
 Corporations
 Limited liability companies
The U.S. has four basic forms of
business organization:
2-5
The Business
Environment
 Oldest form of business organization.
 Business income is accounted for on
your personal income tax form.
Sole Proprietorship -- A business
form for which there is one owner.
This single owner has unlimited
liability for all debts of the firm.
2-6
Summary for
Sole Proprietorship
Advantages
Simplicity
Low setup cost
Quick setup
Single tax filing
on individual form
Disadvantages
 Unlimited liability
 Hard to raise
additional capital
 Transfer of
ownership
difficulties
2-7
The Business
Environment
Business income is accounted
for on each partner’s personal
income tax form.
Partnership -- A business form in
which two or more individuals
act as owners.
2-8
Types of Partnerships
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.
General Partnership -- all partners have
unlimited liability and are liable for all
obligations of the partnership.
2-9
Summary for Partnership
Advantages
 Can be simple
 Low setup cost, higher
than sole
proprietorship
 Relatively quick setup
 Limited liability for
limited partners
Disadvantages
 Unlimited liability for
the general partner
 Difficult to raise
additional capital, but
easier than sole
proprietorship
 Transfer of ownership
difficulties
2-10
The Business
Environment
An artificial entity that can own
assets and incur liabilities.
Business income is accounted
for on the income tax form of the
corporation.
Corporation -- A business form
legally separate from its owners.
2-11
Summary for Corporation
Advantages
Limited liability
Easy transfer of
ownership
Unlimited life
Easier to raise large
quantities of capital
Disadvantages
Double taxation
More difficult to
establish
More expensive
to set up and
maintain
2-12
The Business
Environment
Business income is accounted for on
each “member’s” individual income
tax form.
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.
2-13
Limited Liability
Company (LLC)
 Limited liability
 Centralized management
 Unlimited life
 Transfer of ownership without other
owners’ prior consent
Generally, an LLC will possess only the
first two of the following four standard
corporation characteristics
2-14
Summary for LLC
Advantages
 Limited liability
 Eliminates double
taxation
 No restriction on
number or type of
owners
 Easier to raise
additional capital
Disadvantages
 Limited life
(generally)
 Transfer of
ownership
difficulties
(generally)
2-15
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)
Corporate Income Taxes
2-16
Income Tax Example
Lisa Miller of Basket Wonders
(BW) is calculating the income tax
liability, marginal tax rate, and
average tax rate for the fiscal year
ending December 31.
BW’s corporate taxable income for
this fiscal year was $250,000.
2-17
Income Tax Example
Marginal tax rate = 39%
Average tax rate = $80,750 / $250,000
= 32.3%
Income tax liability
= $22,250 + .39 x ($250,000 - $100,000)
= $22,250 + $58,500
= $80,750
2-18
Depreciation
Generally, profitable firms prefer to use
an accelerated method for tax
reporting purposes.
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.
2-19
Common Types of
Depreciation
 Straight-line (SL)
 Accelerated Types
 Double Declining Balance
(DDB)
 Modified Accelerated Cost
Recovery System (MACRS)
2-20
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
class life.
She calculates the annual depreciation
charges using MACRS. [Note – ignore
“bonus” depreciation discussed in 2-25]
2-21
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
of the asset.
2-22
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
2-23
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
2-24
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.
2-25
Jobs and Growth Tax Relief
Reconciliation Act of 2003
Increase & Extension of Bonus Depreciation
• 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
problems (note – ignored in slide 2-20)
2-26
Other Tax Issues
Quarterly Tax Payments require
corporations to pay 25% of their
estimated annual tax liability on the 15th
of April, June, September, and December.
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.
2-27
Interest Deductibility
Interest Expense is the interest paid on
outstanding debt and is tax 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!
2-28
Handling Corporate
Losses and Gains
 Losses are generally carried back
first and then forward starting with
the earliest year with operating gains.
 Corporations that sustain a net
operating loss can carry that loss
back (Carryback) 2 years and forward
(Carryforward) 20 years to offset
operating gains in those years.
2-29
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?
-$500,000
$100,000
$150,000
$150,000
2007
2006
2005
2004
2-30
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.
-$500,000
$100,000
$150,000
$150,000
2007
2006
2005
2004
-$150,000 -$100,000 $250,000
$150,000 0
0 -$250,000
2-31
Corporate Capital
Gains / Losses
 Often historically, capital gains income
has received more favorable U.S. tax
treatment than operating income.
 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).
2-32
Corporate Capital
Gains / Losses
 Capital losses are deductible
only against capital gains.
 Currently, capital gains are taxed
at ordinary income tax rates for
corporations, or a maximum 35%.
2-33
Personal Income Taxes
The U.S. has a progressive tax
structure with four tax brackets of 10%,
15%, 25%, 28%, 33%, and 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
fluctuate between the marginal rates.
2-34
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
users.
2-35
Flow of Funds
in the Economy
INVESTMENT SECTOR
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
2-36
Flow of Funds
in the Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
INVESTMENT
SECTOR
Businesses
Government
Households
INVESTMENT SECTOR
2-37
Flow of Funds
in the Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SAVINGS
SECTOR
Households
Businesses
Government
INVESTMENT SECTOR
2-38
Flow of Funds
in the Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
BROKERS
Investment
Bankers
Mortgage
Bankers
INVESTMENT SECTOR
2-39
Flow of Funds
in the Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
Commercial Banks
Savings Institutions
Insurance Cos.
Pension Funds
Finance Companies
Mutual Funds
INVESTMENT SECTOR
2-40
Flow of Funds
in the Economy
FINANCIAL
INTERMEDIARIES
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SECONDARY
MARKET
Security
Exchanges
OTC
Market
INVESTMENT SECTOR
2-41
Allocation of Funds
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.
Funds will flow to economic units that are
willing to provide the greatest expected
return (holding risk constant).
2-42
Risk-Expected
Return Profile
RISK
EXPECTED
RETURN
(%)
U.S. Treasury Bills (risk-free securities)
Prime-grade Commercial Paper
Long-term Government Bonds
Investment-grade Corporate Bonds
Medium-grade Corporate Bonds
Preferred Stocks
Conservative Common Stocks
Speculative Common Stocks
2-43
What Influences Security
Expected Returns?
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.
Default Risk is the failure to meet
the terms of a contract.
2-44
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
Elements
BB Speculative
C Lowest Grade D In Default
Investment grade represents the top four categories.
Below investment grade represents all other categories.
2-45
What Influences Expected
Security Returns?
Taxability considers the expected
tax consequences of the security.
Maturity is concerned with the life
of the security; the amount of
time before the principal amount
of a security becomes due.
2-46
Term Structure of
Interest Rates
A yield curve is a graph of the relationship between
yields and term to maturity for particular securities.
Upward Sloping Yield Curve
Downward Sloping Yield Curve
0
2
4
6
8
10
YIELD
(%)
0 5 10 15 20 25 30
(Usual)
(Unusual)
YEARS TO MATURITY
2-47
What Influences Expected
Security Returns?
Inflation is a rise in the average
level of prices of goods and
services. The greater inflation
expectations, then the greater the
expected return.
Embedded Options provide the
opportunity to change specific
attributes of the security.

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Financial_Management_Lectures.ppt

  • 1. 2-1 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
  • 2. 2-2 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.”
  • 3. 2-3 The Business, Tax, and Financial Environments  The Business Environment  The Tax Environment  The Financial Environment
  • 4. 2-4 The Business Environment  Sole Proprietorships  Partnerships (general and limited)  Corporations  Limited liability companies The U.S. has four basic forms of business organization:
  • 5. 2-5 The Business Environment  Oldest form of business organization.  Business income is accounted for on your personal income tax form. Sole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.
  • 6. 2-6 Summary for Sole Proprietorship Advantages Simplicity Low setup cost Quick setup Single tax filing on individual form Disadvantages  Unlimited liability  Hard to raise additional capital  Transfer of ownership difficulties
  • 7. 2-7 The Business Environment Business income is accounted for on each partner’s personal income tax form. Partnership -- A business form in which two or more individuals act as owners.
  • 8. 2-8 Types of Partnerships 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. General Partnership -- all partners have unlimited liability and are liable for all obligations of the partnership.
  • 9. 2-9 Summary for Partnership Advantages  Can be simple  Low setup cost, higher than sole proprietorship  Relatively quick setup  Limited liability for limited partners Disadvantages  Unlimited liability for the general partner  Difficult to raise additional capital, but easier than sole proprietorship  Transfer of ownership difficulties
  • 10. 2-10 The Business Environment An artificial entity that can own assets and incur liabilities. Business income is accounted for on the income tax form of the corporation. Corporation -- A business form legally separate from its owners.
  • 11. 2-11 Summary for Corporation Advantages Limited liability Easy transfer of ownership Unlimited life Easier to raise large quantities of capital Disadvantages Double taxation More difficult to establish More expensive to set up and maintain
  • 12. 2-12 The Business Environment Business income is accounted for on each “member’s” individual income tax form. 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.
  • 13. 2-13 Limited Liability Company (LLC)  Limited liability  Centralized management  Unlimited life  Transfer of ownership without other owners’ prior consent Generally, an LLC will possess only the first two of the following four standard corporation characteristics
  • 14. 2-14 Summary for LLC Advantages  Limited liability  Eliminates double taxation  No restriction on number or type of owners  Easier to raise additional capital Disadvantages  Limited life (generally)  Transfer of ownership difficulties (generally)
  • 15. 2-15 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) Corporate Income Taxes
  • 16. 2-16 Income Tax Example Lisa Miller of Basket Wonders (BW) is calculating the income tax liability, marginal tax rate, and average tax rate for the fiscal year ending December 31. BW’s corporate taxable income for this fiscal year was $250,000.
  • 17. 2-17 Income Tax Example Marginal tax rate = 39% Average tax rate = $80,750 / $250,000 = 32.3% Income tax liability = $22,250 + .39 x ($250,000 - $100,000) = $22,250 + $58,500 = $80,750
  • 18. 2-18 Depreciation Generally, profitable firms prefer to use an accelerated method for tax reporting purposes. 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.
  • 19. 2-19 Common Types of Depreciation  Straight-line (SL)  Accelerated Types  Double Declining Balance (DDB)  Modified Accelerated Cost Recovery System (MACRS)
  • 20. 2-20 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 class life. She calculates the annual depreciation charges using MACRS. [Note – ignore “bonus” depreciation discussed in 2-25]
  • 21. 2-21 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 of the asset.
  • 22. 2-22 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
  • 23. 2-23 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
  • 24. 2-24 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.
  • 25. 2-25 Jobs and Growth Tax Relief Reconciliation Act of 2003 Increase & Extension of Bonus Depreciation • 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 problems (note – ignored in slide 2-20)
  • 26. 2-26 Other Tax Issues Quarterly Tax Payments require corporations to pay 25% of their estimated annual tax liability on the 15th of April, June, September, and December. 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.
  • 27. 2-27 Interest Deductibility Interest Expense is the interest paid on outstanding debt and is tax 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!
  • 28. 2-28 Handling Corporate Losses and Gains  Losses are generally carried back first and then forward starting with the earliest year with operating gains.  Corporations that sustain a net operating loss can carry that loss back (Carryback) 2 years and forward (Carryforward) 20 years to offset operating gains in those years.
  • 29. 2-29 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? -$500,000 $100,000 $150,000 $150,000 2007 2006 2005 2004
  • 30. 2-30 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. -$500,000 $100,000 $150,000 $150,000 2007 2006 2005 2004 -$150,000 -$100,000 $250,000 $150,000 0 0 -$250,000
  • 31. 2-31 Corporate Capital Gains / Losses  Often historically, capital gains income has received more favorable U.S. tax treatment than operating income.  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).
  • 32. 2-32 Corporate Capital Gains / Losses  Capital losses are deductible only against capital gains.  Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%.
  • 33. 2-33 Personal Income Taxes The U.S. has a progressive tax structure with four tax brackets of 10%, 15%, 25%, 28%, 33%, and 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 fluctuate between the marginal rates.
  • 34. 2-34 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 users.
  • 35. 2-35 Flow of Funds in the Economy INVESTMENT SECTOR FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET
  • 36. 2-36 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET INVESTMENT SECTOR Businesses Government Households INVESTMENT SECTOR
  • 37. 2-37 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET SAVINGS SECTOR Households Businesses Government INVESTMENT SECTOR
  • 38. 2-38 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET FINANCIAL BROKERS Investment Bankers Mortgage Bankers INVESTMENT SECTOR
  • 39. 2-39 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET FINANCIAL INTERMEDIARIES Commercial Banks Savings Institutions Insurance Cos. Pension Funds Finance Companies Mutual Funds INVESTMENT SECTOR
  • 40. 2-40 Flow of Funds in the Economy FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET SECONDARY MARKET Security Exchanges OTC Market INVESTMENT SECTOR
  • 41. 2-41 Allocation of Funds 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. Funds will flow to economic units that are willing to provide the greatest expected return (holding risk constant).
  • 42. 2-42 Risk-Expected Return Profile RISK EXPECTED RETURN (%) U.S. Treasury Bills (risk-free securities) Prime-grade Commercial Paper Long-term Government Bonds Investment-grade Corporate Bonds Medium-grade Corporate Bonds Preferred Stocks Conservative Common Stocks Speculative Common Stocks
  • 43. 2-43 What Influences Security Expected Returns? 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. Default Risk is the failure to meet the terms of a contract.
  • 44. 2-44 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 Elements BB Speculative C Lowest Grade D In Default Investment grade represents the top four categories. Below investment grade represents all other categories.
  • 45. 2-45 What Influences Expected Security Returns? Taxability considers the expected tax consequences of the security. Maturity is concerned with the life of the security; the amount of time before the principal amount of a security becomes due.
  • 46. 2-46 Term Structure of Interest Rates A yield curve is a graph of the relationship between yields and term to maturity for particular securities. Upward Sloping Yield Curve Downward Sloping Yield Curve 0 2 4 6 8 10 YIELD (%) 0 5 10 15 20 25 30 (Usual) (Unusual) YEARS TO MATURITY
  • 47. 2-47 What Influences Expected Security Returns? Inflation is a rise in the average level of prices of goods and services. The greater inflation expectations, then the greater the expected return. Embedded Options provide the opportunity to change specific attributes of the security.