Tax Code & Money Market - Financial Management

Tax Code & Money Market – Financial Management Test

This chapter includes discussions on Tax Code & Money Market – Financial Management. Test 1 is based on this chapter.

key features of the tax code

1) corporate taxes 2) individual taxes

proprietorship disadvantages 

limited life unlimited liability difficult to raise capital to support growth

partnership advantages 

ease of formation subject to few regulations no corporate income taxes

partnership disadvantages

 limited life unlimited liability difficult to raise capital to support growth


 a corporation is a legal entity separate from its owners and managers

corporation advantages

 unlimited life easy transfer of ownership limited liability ease of raising capital

corporation disadvantages

 double taxation cost of set-up and report filing 

corporate taxation

1) progressive rate up to $18.3 million taxable income below $18.3M, the marginal rate is not equal to the average rate above $18.3M, the marginal rate and the averate rate are 35% 2) corporations may deduct interst expenses save for dividend payments carry back losses for 2 years, carry forward losses for 20 years exclude 70% of dividend income if it owns less than 20% of the company’s stock

individual taxation

 progressive tax rates from 10-35% capital gains tax rate 15% dividends are taxed the same as capital gains 15% interest on municipal bonds is not taxed at the federal level

agency problem

 managers may act in their own interests and not on behalf of the owners (stockholders)

corporate governance

 the set of rules that control a company’s behavior towards it directors, managers, employees, shareholders, creditors, customers, competitors, and community corporate governance may help control agency problems

management’s primary objective

 maximize shareholder wealth

3 aspects of Cash Flows that affect an investment’s value

 amount of the expected cash flows (bigger = better) timing of the cash flows (sooner = better) risk of the cash flows (less = better)

free cash flows (fcf) 

the cash flows that are available (or free) for distribution to all investors (stockholders and creditors) fcf = sales rev – operating costs – operating taxes – required investments in operating capital

weighted average cost of capital (WACC) 

the average rate of return required by all of the company’s investors

WACC is affected by

 capital structure interest rates risk of the firm investors’ overall attitude toward risk

3 types of transfer of capital from savers to borrowers

1) direct transfer – corporation issues commercial paper to an insurance company 2) through an investment banking house – an IPO, seasoned equity offering, or debt placement–company sells security to the investment banking house which then sells the security to the investor 3) through a financial intermediary – an individual deposits money into a bank and gets a certificate of deposit, then the bank makes a commercial loan to a company

Tax Code & Money Market

the cost of capital

 the interest rate 

objective of the firm

 maximize shareholder wealth

corporate finance provides the skills managers need to

 identify and select corporate strategies and individual projects that add value to their firm forecast the funding requirements of their company and devise strategies for acquiring for those funds

types of business organizations

 sole proprietorship partnership corporation

proprietorship advantages

 ease of formation subject to few regulations no corporate income taxes

the cost of equity

 the cost of equity capital cost of equity = required return required return = dividend yield + capital gain

4 factors that affect the cost of money

 production opportunities time preferences for consumption risk expected inflation

economic conditions that affect the cost of money

 federal reserve policies budget deficits/surpluses level of business activity (recession/boom) international trade deficits/surpluses

international conditions that affect the cost of money

 country risk (political, economic, and social environs) exchange rate risk

factors that affect exchange rate risk

 international trade deficits/surpluses relative inflation and interest rates country risk

money market (debt)

 t-bills cds eurodollars fed funds

money market (equity)


money market (derivatives) 

options futures forward contract

capital market (debt)

 t-bonds agency bonds municipals corporate bonds

capital market (equity)

 common stock preferred stock

capital market (derivatives) 

leaps swaps

financial institutions

 commercial banks investment banks savings and loans mutual savings banks credit unions live insurance companies mutual funds (exchanged traded funds [etfs])) pension funds hedge funds private equity funds

types of markets

 market–a method of exchanging one asset for another physical assets vs. financial assets spot markets vs. future markets money markets vs. capital markets primary markets vs. secondary markets

primary vs. secondary security sales

1) primary new issue (IPO or seasoned) key factor–issuer receives the proceedsd fromt he sale 2) seconday existing owner sells to another party key factor–issuing firms does not reap the proceedsd and is not directly involved in the transaction

secondary market organization

1) by location 2) by the way that orders from buyers and sellers are matched

physical locations vs. computer/telephone networks

1) physical location exchanges nyse amex cbot tokyo stock exchange 2) computer/telephone exchanges nasdaq government bond markets foreign exchanged markets

types of orders 

market order limit order

market order

 transact as quickly as possible at current price

limit order

 transact only if specific situation occurs

auction markets

 participants have a seat on the exchange, meet face-t0-face, and place orders for themselves or for clients nyse and amex are the two largest

dealer markets

 dealers keep an inventory of the stock and place bids and ask advertisements, which are prices at which they are willing to buy and sell nasdaq

electronic communications networks (ecns)

 computerized system matches orders from buyers and sellers and automatically executes transaction

over the counter markets (otc)

 the otc market is the equivalent of a computer bulliten board which allows potential buyers and sellers to post an offer no dealers


 the process of pooling existing (or original) securities and then selling them to investors — the new securities are based on the original securities

free cash flows (fcf)

 the amount of cash available from operations for distribution to all investors a company’s value depends upon the amount of fcf it can generate

5 uses of fcf 

pay interest on debt pay principle on debt pay dividends buy-back stock buy non-operating assets

weighted average cost of capital (wacc)

1) cost of debt market interest rates market risk aversion 2) cost of equity firm’s debt/equity mix firm’s business risk

operating current assets (opca) 

current assets needed to support operations cash inventory receivables

operating current liabilities (opca)

 current liabilities resulting as a normal part of operations accounts payable accrurals

net operating working capital (nowc)

 opca – opcl

net operating profit after taxes (nopat)

 ebit (1 – tax rate)

total net operating capital (operating capital)

 nowc + net fixed assets

return on ivested capital (roic) 

nopat / operating capital

economic value added (eva)

 nopat – wacc * capital

market value added (mva) 

book value of the firm – market value of the firm

market value

 (# shares of stock) (price per share) + value of debt

book value

 total common equity + value of debt