Chapter 2

The
The Business,
Business, Tax,
Tax,
and
and Financial
Financial
Environments
Environments

2.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.”

2.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business, Tax, and
Financial Environments
• The Business Environment
• The Tax Environment
• The Financial Environment

2.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business
Environment
The US has four basic forms of
business organization:
• Sole Proprietorships
• Partnerships (general and limited)
• Corporations
• Limited liability companies
2.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  A proprietorship pays no separate income taxes.
 This business form is widely used in service industries.
 Simplicity is its greatest quality.
 If the organization is sued, the proprietor as an individual is sued
and has unlimited liability, which means that much of his or her
personal property, as well as the assets of the business, may be
seized to settle claims.
 A sole proprietorship may not be as attractive to lenders.
 Tax advantage and disadvantage at the same time.
 Medical coverage, group insurance, educational assistance etc
are not considered as the expenses of the firm and have to be
paid from income left over after paying taxes.

2.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary for
Sole Proprietorship
Advantages Disadvantages
• Simplicity • Unlimited liability
• Low setup cost • Hard to raise
• Quick setup additional capital
• Single tax filing
on individual form

2.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  A partnership, like a proprietorship, pays no
income taxes. Instead, individual partners include
their share of profits or losses from the business
as part of their personal taxable income.
 A greater amount of capital can often be raised.
More than one owner may now be providing
personal capital, and lenders may be more
agreeable to providing funds.

2.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Types of Partnerships
General Partnership – all partners have
unlimited liability and are liable for all
obligations of the partnership.
 Each partner can bind the partnership with obligations, general
partners should be selected with care.
 In most cases a formal arrangement, or partnership agreement,
sets forth the powers of each partner, the distribution of profits,
the amounts of capital to be invested by the partners, procedures
for admitting new partners, and procedures for reconstituting the
partnership in the case of the death or withdrawal of a partner.
 Legally, the partnership is dissolved if one of the partners dies or
2.10
withdraws.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Limited Partnership – limited partners have liability limited to
their capital contribution (investors only). They cannot
loose more than they put in. They do not participate in the
operations of the firm and this is left to the general
partners.
At least one general partner is required and all general
partners have unlimited liability.
 The limited partners are strictly investors, and they share in
the profits or losses of the partnership according to the
terms of the partnership agreement
 This type of arrangement is frequently used in financing
real estate ventures.

2.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary for Partnership

Advantages Disadvantages
• Can be simple • Unlimited
• Low setup cost, liability for the
higher than sole general partner
proprietorship • Difficult to raise
• Relatively quick additional
setup capital, but
2.12 easier than sole
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business
Environment
Corporation – A business form
legally separate from its owners.
• A corporation is an “artificial entity” created by law.
• An artificial entity that can own assets and incur
liabilities.
• Business income is accounted for on the income tax
form of the corporation.

2.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  An owner’s liability is limited to his or her investment.
 Capital can be raised in the corporation’s name without exposing
the owners to unlimited liability.
 Ownership itself is evidenced by shares of stock.
 These shares are easily transferable.
 The corporation exists apart from its owners, its life is not limited
by the lives of the owners.
 Corporate profits are subject to double taxation.
 The company pays tax on the income it earns, and the
stockholder is also taxed when he or she receives income in
the form of a cash dividend.
 Minor disadvantages include the length of time to incorporate and
the red tape involved, as well as the incorporation fee that must be
paid to the state in which the firm is incorporated.
2.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary for Corporation
Advantages Disadvantages
• Limited liability • Double taxation
• Easy transfer of • More difficult to
ownership establish
• Unlimited life • More expensive
• Easier to raise large to set up and
quantities of capital maintain
2.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Business
Environment
Limited Liability Companies – a hybrid form of
business organization that combines the best aspects of both a
corporation and a partnership.
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.
• Preferred mostly by service providing professionals.

2.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The tax environment
 Most business decisions are affected either directly
or indirectly by taxes.
 Through their taxing power, federal, state, and local
governments have a profound influence on the
behavior of businesses and their owners.
 What might prove to be an outstanding business
decision in the absence of taxes may prove to be
very inferior with taxes (and sometimes, vice versa).
 We must be mindful that tax laws frequently change.

2.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Corporate Income Taxes
Corp. Taxable Income Tax
At Least But < Rate Tax Calculation
$ 0 $ 50,000 15% 0.15x(Inc > 0)
50,000 75,000 25% $ 7,500 + 0.25x(Inc > 50,000)
75,000 100,000 34% 13,750 + 0.34x(Inc > 75,000)
100,000 335,000 39% 22,250 + 0.39x(Inc > 100,000)
335,000 10,000,000 34% 113,900 + 0.34x(Inc > 335,000)
10,000,000 15,000,000 35% 3,400,000 + 0.35x(Inc > 10,000,000)
15,000,000 18,333,333 38% 5,150,000 + 0.38x(Inc > 15,000,000)
18,333,333 35% 6,416,667 + 0.35x(Inc > 18,333,333)

2.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Corporate income taxes
 A corporation’s taxable income is found by deducting all
allowable expenses, including depreciation and interest, from
revenues.
 The tax rate - the percentage of taxable income that must be
paid in taxes – that is applied to each income bracket is referred
to as a marginal rate.
 A marginal tax rate is the tax rate an individual would pay on
one additional dollar of income.
 For example, each additional dollar of taxable income above
$50,000 is taxed at the marginal rate of 25 percent until taxable
income reaches $75,000. At that point, the new marginal rate
becomes 34 percent.

2.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  The average tax rate for a firm is measured by
dividing taxes actually paid by taxable
income.
 For example, a firm with $100,000 of taxable
income pays $22,250 in taxes, and therefore
has an average tax rate of $22,250/$100,000,
or 22.25 percent.

2.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Alternative Minimum Tax.

 Companies dislike paying taxes and will take

advantage of all the deductions and credits that the
law allows. Therefore, the Internal Revenue Service
has devised a special tax to ensure that large firms
that benefit from the tax laws pay at least a minimum
amount of tax. This special tax is called the
alternative minimum tax (AMT).
 Alternative Corporate Tax (ACT) implemented in
Pakistan through Finance act 2014. Tax rate is 17%

2.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Income Tax Example
Income tax liability
= $22,250 + 0.39 × ($250,000 –
$100,000) = $22,250 + $58,500
= $80,750
Marginal tax rate = 39%
Average tax rate = $80,750 / $250,000
= 32.3%
Also solve in Excel! – VW13E-02b.xlsx
2.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Depreciation deductions taken on a firm’s tax
return are treated as expense items.
 Thus depreciation lowers taxable income.
 Everything else being equal, the greater the
depreciation charges, the lower the tax.
 There are a number of alternative procedures for
depreciating capital assets, including straight-
line depreciation and various accelerated
depreciation methods.
 The depreciation methods chosen may differ for
tax reporting versus financial reporting.
2.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common Types of
Depreciation
• Straight-line (SL)
• Accelerated Types
• Double Declining Balance
(DDB)
• Modified Accelerated Cost
Recovery System (MACRS)
2.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Straight-line depreciation
 A method of depreciation that
allocates expenses evenly over the
depreciable life of the asset.
 If the fully installed acquisition cost
of a five-year property class asset is
$10,000, annual depreciation charges
using straight-line depreciation
would be $10,000/5, or $2,000.
2.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Accelerated depreciation
 Methods of depreciation that
write off the cost of a capital
asset faster than under straight
line depreciation.

2.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Declining-balance
depreciation
 Methods of depreciation calling for an
annual charge based on a fixed
percentage of the asset’s depreciated
book value at the beginning of the year for
which the depreciation charge applies.
 Under the declining-balance methods the
general formula for determining the
depreciation charge in any period is
 m(1/n)NBV
2.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  where m is the multiple, n is the
depreciable life of the asset, and NBV is
the asset’s net book value at the start of
the year.
 For a $10,000 asset, with a five-year life,
the depreciation charge in the first year
using the DDB method would be
 2(1/5)$10,000 = $4,000

2.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Asset classes under MACRS

2.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 MACRS Example
Depreciation Depreciation Net Book
Year Calculation Charge Value
0 --- --- $100,000
1 0.5X2X(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 0.5 5,760 0

2.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
2.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Interest expense vs
dividends paid
Interest Expense is the interest paid on
outstanding debt and is tax deductible.
However, dividends paid to preferred or
common stockholders are not tax
deductible.
Cash Dividend is the cash distribution of
earnings to shareholders and is not a tax
deductible expense.
2.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Thus, for a profitable, tax-paying
company, the use of debt (e.g.,
bonds) in its financing mix
results in a significant tax
advantage relative to the use of
preferred or common stock.

2.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Given a marginal tax rate of 35
percent, a firm that pays out $1 in
interest lowers its tax bill by 35 cents
because of its ability to deduct the $1
of interest from taxable income.
 The after-tax cost of $1 of interest for
this firm is really only 65 cents

2.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The after-tax cost of debt is :
(Interest Expense) X ( 1 – Tax
Rate)
On the other hand, the after-tax cost of $1 of
dividends paid by the firm is still $1 – there is no
tax advantage here.
Thus, debt financing has a tax advantage!

2.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Dividend income
 A corporation may own stock in another company.
 If it receives a cash dividend on this stock, normally 70 percent of
the dividend is tax exempt.
 The tax laws allows this tax break for corporations (not
individuals) to help reduce the effects of multiple taxation of the
same earnings.
 The remaining 30 percent is taxed at the corporate income tax
rate.
 A firm that receives $10,000 in dividend income pays taxes on only
$3,000 of this income.
 At a marginal tax rate of 35 percent, taxes would amount to
$1,050, as opposed to $3,500 if the entire dividend income were
treated as taxable income.

2.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Tax calculation exercise
 Tripex Consolidated Industries owns $1.5
million in 12 percent bonds of Solow Electronics
Company. It also owns 100,000 shares of
preferred stock of Solow, which constitutes 10
percent of all outstanding Solow preferred
shares. In the past year, Solow paid the
stipulated interest on its bonds and dividends of
$3 per share on its preferred stock. The
marginal tax rate of Tripex is 34 percent. What
taxes must Tripex pay on this interest and
dividend income?
2.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Calculation of Percent Amount Taxes(@34%
income subject to subject to marginal tax
taxes taxes rate)
Interest 1500000*0.12 100% $180000 $61200
earning on =180000 (180000*100
bonds %)
Dividend 100000*3= 30% $90000(3000 $30600
income on 300000 00*30%)
stocks
$91800

2.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Personal Income Taxes
• The US has a progressive tax structure with four
tax brackets of 10%, 15%, 25%, 28%, 33%, and
35%.
• The current maximum cash dividend and capital
gains tax rates is 15%.
• 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.
2.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Handling Corporate
Losses and Gains
• Corporations that sustain a net operating loss(where
a company's allowable tax deductions are greater than its
taxable income. When more expenses than revenues are
incurred during the period) can carry that loss back
(Carryback) 2 years and forward (Carryforward) 20
years to offset operating gains in those years.
• For Pakistan carry backward not allowed, carry forward allowed for the
next six years
• Losses are generally carried back
first and then forward starting with
the earliest year with operating gains.
2.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Corporate Losses
and Gains Example
Lisa Miller is examining the impact of
an operating loss at Basket Wonders
(BW) in 2007. 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

2.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
2.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Environment
 All businesses operate within the financial system, which consists of a
number of institutions and markets serving business firms,
individuals, and governments.
 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.

2.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The purpose of financial
markets
 Financial assets exist in an economy because the savings of
various individuals, corporations, and governments during a
period of time differ from their investment in real assets.
 By real assets, we mean such things as houses, buildings,
equipment, inventories, and durable goods.
 If savings equaled investment in real assets for all economic units
in an economy over all periods of time, there would be no external
financing, no financial assets, and no money or capital markets.
 Each economic unit would be self-sufficient.

2.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The purpose of financial
markets
 A financial asset is created only when the investment of an economic unit
in real assets exceeds its savings, and it finances this excess by
borrowing or issuing stock.
 Of course, another economic unit must be willing to lend. This interaction
of borrowers with lenders determines interest rates.
 In the economy as a whole, savings-surplus units (those whose savings
exceed their investment in real assets) provide funds to savings-deficit
units (those whose investments in real assets exceed their savings).
 This exchange of funds is evidenced by investment instruments, or
securities, representing financial assets to the holders and financial
liabilities to the issuers.
 In modern economies, however, most nonfinancial corporations use more
than their total savings for investing in real assets. Most households, on
the other hand, have total savings in excess of total investment.
 The purpose of financial markets is to efficiently allocate savings to
ultimate users.
2.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Markets
 Financial markets are not so much physical places as they are
mechanisms for channeling savings to the ultimate investors in real
assets.
 Financial markets can be broken into two classes – the money market and
the capital market.
 MONEY MARKET: The market for short-term (less than one year original
maturity) government and corporate debt securities.
 It also includes government securities originally issued with maturities of
more than one year but that now have a year or less until maturity.
 Examples of money market securities
 T Bills, commercial papers, repurchase agreements, negotiable
certificates of deposits etc
 Capital market The market for relatively long-term (greater than one year
original maturity) financial instruments (e.g., bonds and stocks).

2.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Within money and capital markets there exist both primary and secondary
markets.
 Primary market A market where new securities are bought and sold for the
first time (a “new issues” market).
 Here, funds raised through the sale of new securities flow from the
ultimate savers to the ultimate investors in real assets.
 Secondary market: A market for existing (used) securities rather than new
issues.
 Transactions in these already existing securities do not provide additional
funds to finance capital investment.
 E.g The sale of new cars provides cash to the auto manufacturers; the sale
of used cars in the used-car market does not. In a real sense, a secondary
market is a “used-car lot” for securities.
 The existence of a strong secondary market enhances the efficiency of the
primary market.

2.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial intermediaries
 Financial institutions that accept money from savers and use
those funds to make loans and other financial investments in their
own name.
 They include commercial banks, savings institutions, insurance
companies, pension funds, finance companies, and mutual funds.
 Financial intermediation is the process of savers depositing funds
with financial intermediaries (rather than directly buying stocks
and bonds) and letting the intermediaries do the lending to the
ultimate investors. We usually think of financial intermediation
making the markets more efficient by lowering the cost and/or
inconvenience to consumers of financial services.

2.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial brokers
 When brokers bring together parties who need funds with those
who have savings, they are not performing a direct lending
function but rather are acting as matchmakers, or middlemen.
 Investment banker: A financial institution that underwrites
(purchases at a fixed price on a fixed date) new securities for
resale.
 Investment bankers are middlemen involved in the sale of
corporate stocks and bonds. When a company decides to
raise funds, an investment banker will often buy the issue (at
wholesale) and then turn around and sell it to investors (at
retail).
 Mortgage bankers are involved in acquiring and placing
mortgages. These mortgages come either directly from individuals
and businesses or, more typically, through builders and real
estate agents. In turn, the mortgage banker locates institutional
2.55 and other investors
Van Horne for the
and Wachowicz, Fundamentals mortgages.
of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS

SECONDARY MARKET

SAVINGS SECTOR

2.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR
INVESTMENT
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Businesses

SECONDARY MARKET Government

Households
SAVINGS SECTOR

2.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR
SAVINGS
SECTOR

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Households

SECONDARY MARKET Businesses

Government
SAVINGS SECTOR

2.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR
FINANCIAL
BROKERS

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Investment
Bankers
SECONDARY MARKET
Mortgage
Bankers
SAVINGS SECTOR

2.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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

2.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Flow of Funds
in the Economy

INVESTMENT SECTOR
SECONDARY
MARKET

INTERMEDIARIES
FINANCIAL
FINANCIAL BROKERS
Security
Exchanges
SECONDARY MARKET
OTC
Market
SAVINGS SECTOR

2.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
2.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
US Treasury Bills (risk-free securities)

RISK
2.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What Influences Security
Expected Returns?
• Default Risk is the failure to meet
the terms of a contract.
• Marketability or (liquidity) is the
ability to sell a significant volume
of securities in a short period of
time in the secondary market
without significant price
concession.
2.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 Payment Default

Investment grade represents the top four categories.

Below investment grade represents all other categories.
2.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Credit rating companies in
Pakistan
 PACRA (Pakistan Credit Rating Agency Limited
 JCR-VIS Credit Rating Company Limited
 JCR-VIS Credit Rating Co. Ltd. (JCR-VIS) is operating as a
"Full Service" rating agency and enjoying the largest market
share in Pakistan. JCR-VIS is a joint venture between Japan
Credit Rating Agency, Ltd. (JCR) - Japan's premier rating
agency, and Vital Information Services (Pvt.) Limited (VIS) -
Pakistan's only data bank and financial research organization

2.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

2.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.