Chapter2TheFinancialMarketEnvironment13

Chapter2
TheFinancialMarketEnvironment
Instructors Resources
Overview
Moneyandcapitalmarketsandtheirmajorcomponentsareintroducedinthischapter.Firmsneedtoraisecapital
inordertosurvive.Financialinstitutionsgivefirmsaccesstothemoneytheyneedtogrow.However,greedcandrive
financialmanagersandinstitutionstocommitactionsthatgetthemintotroubleandevenforcebankruptcy.These
bankruptciesresultinlimitedcapitalflowstofirms,andboththeyandthewholeeconomycansuffer.Therefore,
financialinstitutionsandmarketsshouldbewellregulated.Thefinalsectioncoversadiscussionoftheimpactof
taxationonthefirmsfinancialactivities.

Suggested Answer to Opener-in-Review Question

Considerabuyerwhopurchasedahomethatmonthfor$150,000,using$30,000ofherownfundsasa
downpaymentandborrowingtheremaining$120,000fromabankviaa30yearmortgage.Twoyearslater,
pricesinPhoenixroseby30percent,andthehousewasworth$195,000.Assumingthataftermakingtwo
yearsofpaymentsonthe30yearmortgage,theoutstandingmortgagebalancewasstill$118,000.How
muchequitydoesthebuyerhaveinherhome?Whatrateofreturnhassheearnedonherinitial$30,000
investment?
Buyersequityinherhome=$195,000$118,000=$77,000
Rateofreturn=($77,000$30,000)$30,000=$156.67%

Answers to Review Questions

1. Thekeyparticipantsinfinancialtransactionsare individuals,businesses, and governments.Theseparties
participatebothassuppliersanddemandersoffunds.Individualsarethenetsuppliers,whichmeansthatthey
savemoredollarsthantheyborrow,whilebothbusinessesandgovernmentsarenetdemandersbecausethey
borrowmorethantheysave.Onecouldsaythatindividualsprovidetheexcessfundsrequiredbybusinesses
andgovernments.

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14Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

Financialinstitutionsincludecommercialbanksandinvestmentbanks.Theformerassistsbothindividualsand
companieswiththeirbankingneeds,whilethelatterconcentrateseffortsintheareaofassistingcorporations
withraisingfunds.Untilthelate1990s,theGlassSteagallActcreatedaseparationbetweenthetwo.Ashadow
bankingsystem,wherenondeposittakingenterpriseslendmoneytofirmsneedingcash,hasgrowntobeas
largeasthetraditionalbankingsystem.
2. Financialmarketsprovideaforuminwhichsuppliersoffundsanddemandersofloansandinvestmentscan
transactbusinessdirectly.
Primarymarketisthenameusedtodenotethefactthatasecurityisbeingissuedbythedemanderoffundsto
thesupplieroffunds.AnexamplewouldbeMicrosoftCorporationsellingnewsharesofcommonstocktothe
public.
Secondarymarketreferstothetradingofsecuritiesamonginvestorssubsequenttotheprimarymarket
issuance.Insecondarymarkettrading,nonewfundsarebeingraisedbythedemanderoffunds.Thesecurity
istradingownershipamonginvestors.AnexamplewouldbeindividualAbuyingcommonstockof
MicrosoftthroughabrokerfromindividualB.
Financialinstitutionsandfinancialmarketsarenotindependentofeachother.Itisquitecommontofind
financialinstitutionsactivelyparticipatinginboththemoneymarketandthecapitalmarketasbothsuppliers
anddemandersoffunds.Financialinstitutionsoftenchanneltheirinvestmentsandobtainneededfinancing
throughthefinancialmarkets.Thisrelationshipexistsbecausetheseinstitutionsmustusethestructureofthe
financialmarketplacetofindasupplieroffunds.
3. Themoneymarketiscreatedbyafinancialrelationshipbetweenthesuppliersanddemandersofshortterm
debtsecuritiesmaturinginoneyearorless,suchasU.S.Treasurybills,commercialpaper,andnegotiable
certificatesofdeposit.TheEurocurrencymarketistheinternationalequivalentoftheU.S.moneymarketand
isusedforshorttermbanktimedepositsdenominatedindollarsorothermajorcurrencies.
4. Thecapitalmarketisafinancialrelationshipcreatedbyanumberofinstitutionsandarrangementsthatallows
thesuppliersanddemandersoflongtermfunds(withmaturitiesgreaterthanoneyear)tomaketransactions.
Thekeysecuritiestradedinthecapitalmarketsarebondspluscommonandpreferredstock.
5. Thebrokermarketconsistsofnationalandregionalsecuritiesexchanges.Theseorganizationsprovidea
location,suchastheNewYorkStockExchange,tobringtogetherthebuyersandsellersofdebtandequity.
Theycreateacontinuousmarketforsecurities,allocatescarcecapital,determineandpublicizesecurityprices,
andaidinnewfinancing.
Incontrast,dealermarketsareelectronicmarketsforthebuyersandsellersofsecuritiesnotlistedonthe
majorexchanges.Inadealermarket,physicaltradinglocationsarereplacedbysecuritydealerswhoofferto
buyorsellsecuritiesatstatedbid/askprices.Dealersbuysecuritiesfromclientsandsellthemtoother
dealers,whointurnsellthemtotheirclients.Amajorityofsharestradedinthedealermarketarelistedon
Nasdaq,theNationalAssociationofSecuritiesDealersAutomatedQuotationSystem.

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Chapter2TheFinancialMarketEnvironment15

6. InadditiontotheU.S.capitalmarkets,corporationscanraisedebtandequityfundsincapitalmarketslocated
inothercountries.TheEurobondmarketistheoldestandlargestinternationaldebtmarket.Corporateand
governmentbondsissuedinthismarketaredenominatedindollarsorothermajorcurrenciesandsoldto
investorsoutsidethecountryinwhosecurrencythebondsaredenominated.Foreignbondmarketsalso
providecorporationswiththeopportunitytotapothercapitalsources.Corporationsorgovernmentsissue
bondsdenominatedinthelocalcurrencyandsoldonlyinthathomemarket.Theinternationalequitymarket
allowscorporationstosellblocksofstocktoinvestorsinseveralcountries,providingadiversifiedinvestor
baseandadditionalopportunitiestoraiselargeramountsofcapital.
7. Anefficientmarketwillallocatefundstotheirmostproductiveusesduetocompetitionamongwealth
maximizinginvestors.Pricesareassumedtobeafunctionofinformationaboutthefirmandeconomy.Only
new,unexpectedinformationwillcauseinvestorstobuyorsellsecurities.Investorsdeterminethepriceof
assetsthroughtheirparticipationinthefinancialmarkets.Changesinsupplyanddemandcontinuallyimpact
pricesinanefficientmarket.
Analternateviewofmarketpricingisputforthbyadvocatesofbehavioralfinance.Thisexplanationofmarket
pricescombinesfinanceandpsychology.Thoughpricesmaydeviatefromtruevalueforpsychologicaland
otherreasons,fewinvestorshavebeenabletoearnariskadjusted,positiverateofreturn.
8. Securitizationistheprocessofpoolingmortgagesandthensellingclaimsagainstthatpoolinthesecondary
market.Investorsbuyingthesesecuritiesextendaloantothehomeowner.
9. Mortgagebackedsecuritiesrepresentclaimsonthecashflowsgeneratedbyapoolofmortgages.Asthe
homeownerspayofftheirmortgages,themoneyservesasincometotheinvestors.Theprimaryrisk
associatedwithmortgagebackedsecuritiesisthathomeownersmaynotrepaytheirloans.
10. Whenahomeownerborrowsmoneytobuyahome,heborrowsafixedamountofmoney.Ashousingprices
rise,thegapbetweenwhatheowesandwhatthehouseisworthwidens.Lenderswillallowborrowerswho
havedifficultymakingmortgagepaymentstapthisbuiltupequity.Therefore,mortgagedefaultratesare
relativelylow.
11. Ashomepricesdecline,thevalueofhomesmaybelessthantheamountowedtothebank.Hencemany
borrowerswillsimplywalkawayfromtheirhomesandletlendersrepossessthem.Therewillbeanadded
supplyofhousing.Ifmultiplehomesintheareaarefacingforeclosure,thevalueofremaininghomeswill
drop.Atthesametime,borrowershavingtroublemakingmortgagepaymentswillnotbeabletotapintoany
builtupequity.Thesehomeswillalsoberepossessed,andthenumberofhomesforsaleinanareawillrise.
Excesshomeavailabilitywillmaketheremaininghomeslessvaluable,increasingthenumberofhomeowners
withhousesworthlessthantheamountowedtothebank.
12. Acrisisinthefinancialsectorgenerallyhasaspillovereffectontheothersectorsoftheeconomy.Thiscan
bebetterunderstoodbyunderstandingthe2008financialcrisis.Asmortgagebackedsecuritydelinquency
ratesrose,thevalueofstillsolventmortgagebackedsecuritiesfell.Thisfallledtothequestionsaboutthe
solvencyofinvestors,includingfinancialinstitutions.Financialinstitutionscutbackontheamountof
lending,requiringhigherstandardsforthoseborrowingmoney.Unabletoobtainmoneyeasilyinthemoney
market,firmsbegantohoardcashandcutbackexpenditures.Thisdeclinehurtsuppliersandcurtailed
employmentatcompanies.Throughouttheeconomy,revenuesfellasfinancialinstitutionscutbackon
lending.

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16Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

13. Duetotheirenormousimpact,governmentstypicallyregulatefinancialinstitutionsmorethanmosteconomic
sectors.BankingsectortroublesandotherfactorscontributedtotheworsteconomiccontractioninU.S.
historyduringtheGreatDepression.Consequently,itisnotsurprisingthatanaboveaverageamountof
legislationwasenactedinthe1930s.
14. TheSecuritiesActof1933wasdesignedtoregulateactivityintheprimarymarket,ensuringthatsellersof
newsecuritiesprovidedextensivedisclosure.TheSecuritiesExchangeActof1934regulatesthetradingof
securitiesinsecondarymarkets.ThelatterlegislationalsocreatedtheSecuritiesExchangeCommissionto
enforcefederalsecuritieslaws.
15. Theordinaryincomeofacorporationisincomeearnedthroughthesaleofafirmsgoodsorservices.Taxes
oncorporateordinaryincomehavetwocomponents:afixedamountonthebasefigureforitsincomebracket
level,plusaprogressivepercentage,rangingfrom15%to39%,appliedtotheexcessoverthebasebracket
figure.Acapitalgainoccurswhenacapitalassetissoldformorethanitsinitialpurchaseprice.Capitalgains
areaddedtoordinaryincomeandtaxedattheregularcorporaterates.Theaveragetaxrateiscalculatedby
dividingtaxespaidbytaxableincome.Forfirmswithtaxableincomeof$10millionorless,itrangesfrom
15%to34%.Forfirmswithtaxableincomeinexcessof$10million,itrangesbetween34%and35%.The
marginaltaxrateistherateatwhichadditionalincomeistaxed.
16. Dividendsreceivedfromanothercorporation,inwhichtheshareholdingfirmspositionislessthanonefifth
ofoutstandingshares,issubjecttoa70%exclusionfortaxpurposes.Thetaxrateisonly30%ofwhatit
wouldbeonfullytaxableincome.
17. Thetaxdeductibilityofcorporateexpensesreducestheiractualaftertaxcost.Corporateinterestisatax
deductibleexpense,whiledividendsarenot.

Suggested Answer to Focus on Practice Box: Berkshire Hathaway: Can

Buffet Be Replaced?
ThesharepriceofBRKAhasneverbeensplit.Whymightthecompanyrefusetosplititssharestomake
themmoreaffordabletoaverageinvestors?
TheprimaryreasonthatBerkshireHathawaydoesnotsplitthepriceofitscommonstockisbecauseWarren
Buffettsphilosophyisthatastocksplitisfinanciallymeaninglessandonlyservesasawaytolowerthestock
pricesothatmoreinvestorsareabletopurchasethestock.Mr.Buffetthasstatedhisbeliefthattrueinvestorsare
longterminvestorswhoholdastockthroughthickandthin.Withfewershareholders,therearefewerpeoplethat
thecompanymanagementmustanswerto,andinvestorswhocanaffordthesteeppriceoftheBerkshireHathaway
stockarelikelytobeseriousindividualinvestorsorinstitutionalinvestorssuchasmutualfunds.

Suggested Answer to Focus on Ethics Box: The Ethics of Insider

Trading
Ifefficiencyisthegoaloffinancialmarkets,isallowingordisallowinginsidertradingmoreunethical?
Priceefficiencydoesnotnecessarilyimplythatinsidertradingiseitherethicalorunethical.Theefficientmarket
hypothesissuggeststhatstockpricesreflectallpubliclyavailableinformation.Thoseinfavorofallowinginsider

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Chapter2TheFinancialMarketEnvironment17

tradingarguethatitwillallowprivateinformationtobecomepublicfaster,allowingpricestoadjustmorerapidly
tothisinformation.
Doesallowinginsidertradingcreateanethicaldilemmaforinsiders?
Itcertainlycould.ConsiderFamaspointdiscussedinthecase.Ifinsidertradingisallowed,insidersmighthave
theincentivetoholdbackinformationinordertoprofitfromtheinformationbeforereleasingittothepublic.If
thiswerethecase,stockpricescouldimpoundinformationmoreslowlywheninsidertradingispermitted.

Answers to Warm-Up Exercises

E21.

Suppliersanddemandersoffunds

Answer: Individualsasawholespendlessthantheyearn.Theexcessisinvested,makingitavailablefor
businesses.Ifindividualsconsumemore,fewerdollarswillbeavailableforinvestment.Thiswould
reducetheamountofmoneyavailablefornewprojectsanddriveuptherequiredreturn(i.e.,required
returnofinvestorsbuybonds).Overtime,employment,salaries,andgrossdomesticproductwould
decline.
E22

Raisingfunds

Answer: Financialinstitutions,suchasinvestmentbanks,provideexpertiseintheacquisitionoffunds.
Investmentbankinginstitutionsareabletousetheexpertisedevelopedthroughtheacquisitionoffunds
formanyfirmstoreducetheeffortandcostofacquiringfundsforanysinglebusiness.Theinvestment
bankinginstitutionwillallowtheGagaEnterprisesCFOtoraisemoremoneyatalowercostperdollar
raised.
E23

Moneymarketvs.capitalmarket

Answer: Moneymarketsareshorttermmarkets,sofirmsusingthesewouldbeinneedoffundsforlessthana
year.Perhapsthebusinessneedstoincreaseinventoryforaseason,suchasRVdealershipsbuilding
inventorypriortothespring/summersalesperiod.Immediatelyafteralargesale,abusinessmayneed
tofinancethepresenceofaccountsreceivableontheirbalancesheet.Capitalmarkets,bycontrast,
typicallyareusedforfixedassets,whichacompanywilluseoverseveralyears.
E24

Mortgagebackedsecurities

Answer: Questionsyouwouldaskinclude
a. Realestatelocation(afterall,thethreemostimportantdeterminantsofrealestatepriceare
location,location,location)
b. Percentageofpropertiesintheregionthatareunderwater(homeownersowemorethanthey
borrowed)orinforeclosure
c. Typeofrealestate(commercialpropertiesofferlessliquidityifthemarketturnssour,because
emptyhomescanberentedforrevenue)
d. Precedenceinbankruptcy(wouldotherlendershaveaseniorclaimtopropertiesinbankruptcy?)
e. Qualityofrealestate(isitingoodcondition,orwouldthereneedtoberepairspriortosale?)
f. Creditworthinessofborrowers(howlikelyisitthatborrowerswilllosetheirjobandbeunableto
makepaymentsonatimelybasis?)
g. Whatpercentageofborrowersarebehindontheirmortgagepayments?

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18Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

h. Willborrowerssoonbeexperiencinganinterestrateincreasebecausetheytookoutamortgage
withalowinitialratethatwasadjustableafteraperiodoftime?
E25

Biggestbenefitofgovernmentregulation

Answer: Whilethetypeandlevelofgovernmentregulationwillalwaysbedebatable,theideathatweneedand,
infact,benefitfromsomelevelofgovernmentregulationoffinancialinstitutionsandmarketsisquite
reasonable.Thebiggestbenefitofgovernmentregulationistheresultingtrustandconfidenceinthe
financialinstitutionsandmarketsderivedbysociety.Thistrustandconfidenceisnecessarytoensure
societysparticipationinthefinancialmarketenvironmentthatnearlyindividualinonewayoranother
hopestobenefitfrom.
E26.

Dividendsreceivedexclusion

Answer: While100%ofcorporateinterestincomeistaxedatordinarytaxrates,only30%ofcorporatedividend
incomeistreatedastaxableincome.Thiswouldbetheequivalentofrecognizingonly1.5%[5%(1
0.7)]ofthe5%annualdividendfortaxpurposes.Basedsolelyonthetaxtreatmentofcorporate
dividendincomevs.interestincome,Pruro,Inc.,wouldhavegreateraftertaxincomeifitchoosesthe
Restonstockpaying5%dividendsoverthepromissorynotepaying5%interest.

Solutions to Problems
P21.

Corporatetaxes
LG6;Basic
a. Firmstaxliabilityon$92,500(fromTable2.1):
Totaltaxesdue $13,750[0.34($92,500$75,000)]
$13,750(0.34$17,500)
$13,750$5,950
$19,700
b. Aftertaxearnings:$92,500$19,700$72,800
c. Averagetaxrate:$19,700$92,50021.3%
d. Marginaltaxrate:34%

P22.

Averagecorporatetaxrates
LG6;Basic
a.

TaxcalculationsusingTable2.1:
$10,000:

Taxliability:

$10,0000.15$1,500

Aftertaxearnings: $10,000$1,500$8,500
Averagetaxrate: $1,500$10,00015%
$80,000:

Taxliability:

$13,750[0.34(80,000$75,000)]
$13,750(0.34$5,000)
$13,750$1,700
$15,450Totaltax
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Chapter2TheFinancialMarketEnvironment19

Aftertaxearnings: $80,000$15,450$64,550
Averagetaxrate: $15,450$80,00019.3%
$300,000:

Taxliability:

$22,250+[0.39($300,000$100,000)]
$22,250(0.39$200,000)
$22,250$78,000
$100,250Totaltax

Aftertaxearnings: $300,000$100,250$199,750
Averagetaxrate: $100,250$300,00033.4%

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20Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

$500,000:

Taxliability:

$113,900[0.34($500,000$335,000)]
$113,900(0.34$165,000)
$113,900$56,100
$170,000Totaltax

Aftertaxearnings: $500,000$170,000$330,000
Averagetaxrate: $170,000$500,00034%
$1,500,000:

Taxliability:

$113,900[0.34($1,500,000$335,000)]
$113,900(0.34$1,165,000)
$113,900$396,100
$510,000Totaltax

Aftertaxearnings: $1,500,000$510,000$990,000
Averagetaxrate: $510,000$1,500,00034%
$10,000,000: Taxliability:

$113,900+[0.34($10,000,000$335,000)]
$113,900(0.34$9,665,000)
$113,900$3,286,100
$3,400,000Totaltax

Aftertaxearnings: $10,000,000$3,400,000$6,600,000
Averagetaxrate: $3,400,000$10,000,00034%
$20,000,000: Taxliability:

$6,416,667[0.35($20,000,000$18,333,333)]
$6,416,667(0.35$1,666,667)
$6,416,667583,333
$7,000,000Totaltax

Aftertaxearnings: $20,000,000$7,000,000$13,000,000
Averagetaxrate: $7,000,000$20,000,00035%
b.

Asincomeincreases,theratereaches35%.

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Chapter2TheFinancialMarketEnvironment21

P23.

Marginalcorporatetaxrates
LG6;Basic
a.
TaxCalculation
PreTax
Income

BaseTax

Amount
OverBase

Total
Tax

$15,000

$0

(0.15

60,000

7,500

(0.25

90,000

13,750

200,000

22,250

400,000

Marginal
Rate

15,000)

$2,250

15.0%

10,000)

10,000

25.0%

(0.34

15,000)

18,850

34.0%

(0.39

100,000)

61,250

39.0%

113,900

(0.34

65,000)

136,000

34.0%

1,000,000

113,900

(0.34

665,000)

340,000

34.0%

20,000,000

6,416,667

(0.35

1,666,667)

7,00,000
0

35.0%

b.

Asincomeincreasesto$335,000,themarginaltaxrateapproachesandpeaksat39%.Forincomein
excessof$335,000,themarginaltaxratedeclinesto34%,andafter$10million,themarginalrate
increasesslightlyto35%.

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22Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

P24.

Interestvs.dividendincome
LG6;Intermediate
a. Taxonoperatingearnings:$490,0000.40taxrate$196,000
b.andc.

Beforetaxamount

(b)
InterestIncome

(c)
DividendIncome

$20,000

$20,000

14,000

20,000

6,000

8,000

2,400

12,000

17,600

Less:Applicableexclusion
Taxableamount
Tax(40%)
Aftertaxamount

(0.70$20,000)

d. Theaftertaxamountofdividendsreceived,$17,600,exceedstheaftertaxamountofinterest,
$12,000,duetothe70%corporatedividendexclusion.Thisincreasestheattractivenessofstock
investmentsbyonecorporationinanotherrelativetobondinvestments.
e. Totaltaxliability:
Taxesonoperatingearnings(froma.)
Taxesoninterestincome(fromb.)
Taxesondividendincome(fromc.)
Totaltaxliability
P25.

$196,000
8,000
2,400
$206,400

Interestvs.dividendexpense
LG6;Intermediate
a.

EBIT
Less:Interestexpense
Earningsbeforetaxes
Less:Taxes(35%)
Earningsaftertaxes*

$50,000
12,000
$38,000
13,300
$24,700

Thisisalsoearningsavailabletocommonstockholders.

b. EBIT
Less:Taxes(35%)
Earningsaftertaxes
Less:Preferreddividends
Earningsavailablefor
commonstockholders

$50,000
17,500
$32,500
12,000
$20,500

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Chapter2TheFinancialMarketEnvironment23

P26.

Capitalgainstaxes
LG6;Basic
a.

Capitalgain:
AssetX$2,250$2,000$250
AssetY$35,000$30,000$5,000
b. Taxonsaleofasset:
AssetX$2500.40$100
AssetY$5,0000.40$2,000
P27.

Capitalgainstaxes
LG6;Basic
a.andb.
Tax
(3)0.40
(4)

PurchasePrice
(2)

$3,400

$3,000

$400

$160

12,000

12,000

80,000

62,000

18,000

7,200

45,000

41,000

4,000

1,600

18,000

16,500

1,500

600

Asset

P28.

CapitalGain
(1)(2)
(3)

SalePrice
(1)

Ethicsproblem
LG5;Intermediate
Theprimaryethicalissueiswhethertheinsiderisbasinghisbuyorsaleofcompanysharesoninternal
information.Ifheisbasinghisdecisionsoninformationnotavailabletothegeneralpublic,hewouldbe
makingdecisionsinanunethicalmanner.Theinsidermay,forinstance,beawareofthelikelihoodofa
favorableacquisitionandunethicallybuycompanysharesonthatknowledge.Ontheotherhand,insider
salesbaseduponsoontobereleasedinformationaboutthelossofanimportantcontracttoacompetitor
wouldalsobeunethical.

Case
Casestudiesareavailableonwww.myfinancelab.com.

The Pros and Cons of Being Publicly Listed

a. Beingapubliclylistedcompanyprovidesaccesstothemoneythecompanyneedstogrow.Shareholdersalso
providecashwithouthavinganabilitytotakethecompanytobankruptcycourtifapaymentisnotmade.
Goingpublicgivestheownerachancetogetareturnforhisorherhardeffort.Bygoingpublic,theowner
candiversifyhisorherportfolio.Infact,withoutgoingpublic,itisdifficulttodeterminethevalueofthefirm.

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24Gitman/ZutterPrinciplesofManagerialFinance,Fourteenth Edition

b. Therearemanydisadvantagestogoingpublic.One,thereisnoguaranteethatshareholderswillwantto
investinonesfirm.Iftheyavoiditsshares,itwillbepricedbelowexpectedvalue.Therealsomaybelow
tradingvolume.Anotherdisadvantageisthatgoingpublicleavestheowneropenstothepotentialthatan
individualorfirmmightpurchaseallthepubliclyavailableshares,oratleastenoughtocontroltheboardof
directors,andremovethefounderfromthemanagementteam.
c. NotenoughinformationisprovidedtodeterminewhetherRoboTechmeetsthelistingrequirementstobeon
theNYSEEuronext.Thatwouldbethegoalbecauseitisthelargestandhasthelargestnumberofpotential
investors.
d. Capitalmarketefficiencyisimportantformanyreasons.Ifthemarketisefficient,pricesareanunbiasedestimate
offirmvalue.Thebettertheestimateoffairvaluethemoreconfidenceinvestorshaveinthemarketplace.
HavinganincreasednumberofpotentialinvestorshelpsRoboTechsellsharesnowandinthefuture,asit
continuestoneedfundstofinanceexpansions.
(Studentsmayexpandontheseanswers.)

Spreadsheet Exercise
TheanswertoChapter2sHemingwayCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.

Group Exercise
ThereisnogroupexerciseforChapter2.

Integrative Case 1: Merit Enterprise Corp.

a. TherearelimitedbenefitsandriskswithOption1.Withtheloan,Meritwillobtainthemoneyneededand
willhavetomakeperiodicreportsregardingitsfinancialconditiontothelenders.Option1resultsinan
interestexpenseandfixeddatefortherepaymentofprincipal.Asasoleproprietorship,however,Meritwould
havelessaccesstocapitalmarketswhenitapparentlyneedsalargecashinfusiontoenablealargeproduction
expansion.
b. Option2hasamuchgreaterpotentialtoimpactMerit.Ifthefirmsrecentfinancialperformancehasresulted
inthisbeinganidealtimetogopublic,simplyborrowingtheneededfundswouldholdbackthewealththat
couldbeamassedbyMeritsowners.Asshareholders,thenewownerswouldnotbeabletoforceMeritinto
bankruptcy.Infact,thenewownersmaynotbepaidadividendatallforseveralyears.Furthermore,being
publicallowsemployeestobenefitiftheirfirmsucceeds.
Otherbenefitsincludethefactthatincorporations,ownershavelimitedliability.Thiswouldallowthe
currentownerstoonlyhavetheirremaininginvestmentatriskofcompleteloss.StocksalesmayallowMerit
tobecomelarger.ThecorporateformofbusinessalsoextendsMeritslifebeyondthelifetimeofthecurrent
owner(s).

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Chapter2TheFinancialMarketEnvironment25

Ontheotherhand,goingpublicopensMerituptoavarietyofissues.Thereisacostoftheinitialpublicissue
andthesubsequentreportingtothepublic.Thisreportingwillgivecompetitorsmoreinsightintothe
company.Also,amajorityofsharesmightbeobtainedbyasingleindividualorbusiness,effectively
acquiringMerit.
Ofcourse,thetypicaldisadvantagesofthecorporateformofownershipwouldapply.Meritwouldpay
corporatetax.Therealsotendstobegreatergovernmentalregulationofcorporations.
c. SaraLehnshouldmakeherdecisiononthebasisofwhichoptionwillmaximizethewealthofthecurrent
owners.Meritsfinefinancialperformancewillreportedlycommandahighpriceandmakeitpossibleto
offerincentivestoemployees.Theriskswouldbespreadoutbetweenthecurrentownersandnewowners.
Therefore,SarashouldproposethatMeritgoespublicattheupcomingmeetingoftheboardofdirectors.

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