And Financial Environments

Corporation, n. An ingenious device for obtaining individual profit without individual responsibility.

AMBROSE BIERCE The Devil's Dictionary

ANSWERS TO QUESTIONS

1. The principal advantage of the corporate form of business organization is that the corporation has limited liability. The owner of a small family restaurant might be required to personally guarantee corporate borrowings or purchases anyway, so much of this advantage might be eliminated. The wealthy individual has more at stake and unlimited liability might cause one failing business to bring down the other, healthy businesses.

2. The liability is limited to the amount of the investment in both the limited partnership and in the corporation. However, the limited partner generally does not have a role in selecting the management or in influencing the direction of the enterprise. On a pro rata basis, stockholders are able to select management and affect the direction of the enterprise. Also, partnership income is taxable to the limited partners as personal income whereas corporate income is not taxed unless distributed to the stockholders as dividends.

3. With both a sole proprietorship and partnership, a major drawback is the legal liability of the owners. It extends beyond the financial resources of the business to the owners personally. Fringe benefits are not deductible as an expense. Also, both forms of organization lack the corporate feature of "unlimited life." With the partnership there are problems of control and management. The ownership is not liquid when it comes to planning for individual estates. Decision making can be cumbersome. An LLC generally lacks the feature of "unlimited life," and complete transfer of an ownership interest is usually subject to the approval of at least a majority of the other LLC members.

4. The chief beneficiaries are smaller companies where the first $75,000 in taxable income is a large portion, if not all, of their total taxable income.

5. Accelerated depreciation is used up to the point it is advantageous to switch to straight line depreciation. A one-half year convention is followed in the first year, which reduces the cost recovery in that year from what would otherwise be the case. Additionally, a one-half year convention is followed in the year following the asset class. This pushes out the depreciation schedule, which is disadvantageous from a present value standpoint. The double declining balance method is used for the first four asset classes, 3, 5, 7 and 10 years. The asset category determines the project's depreciable life.

6. The immunity from each other's taxing power dates back to the early part of the 19th century. It used to apply to salaries of government employees as well. The exemption is historical, and it is hard to rationalize from the standpoint of economic/taxing efficiency.

7. Personal tax rates are progressive up to a point, then become regressive.

8. With the differential taxation of ordinary income and capital gains, securities with a higher likelihood of capital gains are tax advantaged. These include low dividend common stocks, common stocks in general, discount bonds, real estate, and other investments of this sort.

9. Depreciation changes the timing of tax payments. The longer these payments can be delayed, the better off the business is.

10. One advantage to Subchapter S occurs when investors have outside income against which to use losses by the company. Even with no outside income, stockholders still may find Subchapter S to be advantageous. If dividends are paid, the stockholder under Subchapter S is subject only to taxation on the profits earned by the company. Under the corporate method, the company pays taxes on its profits and then the owners pay personal income taxes on the dividends paid to them.

11. Tax incentives are the result of special interest groups influencing legislators. For example, exporters influenced the passage of DISCs. Doctors and attorneys influenced the passage of the Keogh pension plans. Some of these incentives benefit society as a whole; others benefit only a few at the expense of the rest of society. It is hard to imagine all individuals placing the interest of the whole above their own interests. Therefore, it is difficult to perceive that tax incentives will be discontinued. Further, some incentives can be used to benefit large groups of people.

12. The purpose of the carryback and carryforward provisions is to allow the cyclical company with large profit swings to obtain most of the tax benefits available to a company with more steady profits. Also, the provision protects the company with a large loss in a given year. While if a company has steady losses it does not benefit from this provision, the marginal company with profit swings does.

13. Financial markets allow for efficient allocation in the flow of savings in an economy to ultimate users. In a macro sense, savings originate from savings-surplus economic units whose savings exceed their investment in real assets. The ultimate users of these savings are savings-deficit economic units whose investments in real assets exceed their savings. Efficiency is introduced into the process through the use of financial markets. Since the savings-surplus and savings-deficit units are usually different entities, markets serve to channel these funds at the least cost and inconvenience to both. As specialization develops, efficiency increases. Loan brokers, secondary markets, and investment bankers all serve to expedite this flow from savers to users.

14. Financial intermediaries provide an indirect channel for the flow of funds from savers to ultimate users. These institutions include commercial banks, savings and loan associations, life insurance companies, pension and profit-sharing funds and savings banks. Their primary function is the transformation of funds into more attractive packages for savers. Services and economies of scale are side benefits of this process. Pooling of funds, diversification of risk, transformation of maturities and investment expertise are desirable functions that financial intermediaries perform.

15. Differences in maturity, default risk, marketability, taxability, and option features affect yields on financial instruments. In general, the longer the maturity, the greater the default risk, the lower the marketability and the more the return is subject to ordinary income taxation as opposed to capital gains taxation or no taxation, the higher the yield on the instrument. If the investor receives an option (e.g., a conversion feature or warrant), the yield should be lower than otherwise. Conversely, if the firm issuing the security receives an option, such as a call feature, the investor must be compensated with a higher yield. Another factor -- one not taken up in this chapter -- is the coupon rate. The lower the coupon rate, the greater the price volatility of a bond, all other things the same, and generally the higher the yield.

16. The market becomes more efficient when the cost of financial intermediation is reduced. This cost is represented by the difference in interest rate between what the ultimate saver receives and what the ultimate borrower pays. Also, the inconvenience to one or both parties is an indirect cost. When financial intermediation reduces these costs, the market becomes more efficient. The market becomes more complete when special types of financial instruments and financial processes are offered in response to an unsatisfied demand by investors. For example, the new product might be a zero-coupon bond and the new process, automatic teller machines.

17. These exchanges serve as secondary markets wherein the buyer and seller meet to exchange shares of companies that are listed on the exchange. These markets have provided economies of time and scale in the past and have facilitated exchange among interested parties.

18. a) All other things the same, the cost of funds (interest rates)

would rise. If there are no disparities in savings pattern, the effect would fall on all financial markets.

b) Given a somewhat segmented market for mortgages, it would result in mortgage rates falling and rates on other financial instruments rising somewhat.

c) It would lower the demand for common stock, bonds selling at a discount, real estate, and other investments where capital gains are an attraction for investment. Prices would fall for these assets relative to fixed income securities until eventually the expected returns after taxes for all financial instruments were in equilibrium.

d) Great uncertainty would develop in the money and capital markets and the effect would likely be quite disruptive. Interest rates would rise dramatically and it would be difficult for borrowers to find lenders willing to lend at a fixed interest rate. Disequilibrium would likely continue to occur until the rate of inflation reduced to a reasonable level.

e) Financial markets would be less efficient in channeling funds from savers to investors in real estate.

19. Answers to this question will differ depending on the financial intermediary that is chosen. The economic role of all is to channel savings to investments at a lower cost and/or with less inconvenience to the ultimate borrower and to the ultimate saver than would be the case in their absence. Their presence improves the efficiency of financial markets in allocating savings to the most productive investment opportunities.

20. Money markets serve the short-term liquidity needs of investors. The usual line of demarkation is one year; money markets include instruments with maturities of less than a year while capital markets involve securities with maturities of more than one year. However, both markets are financial markets with the same economic purpose so the distinction of maturity is somewhat arbitrary. Money markets involve instruments that are impersonal; funds flow on the basis of risk and return. A bank loan, for example, is not a money-market instrument even though it might be short term.

21. Transaction costs impede the efficiency of financial markets. The larger they are, the less efficient are financial markets. Financial institutions and brokers perform an economic service for which they must be compensated. The means of compensation is transaction costs. If there is competition among them, transaction costs will be reduced to justifiable levels.

22. The major sources are bank loans, bond issues, mortgage debt, and stock issues.

23. Financial brokers, such as investment bankers in particular as well as mortgage bankers, facilitate the matching of borrowers in need of funds with savers having funds to lend. For this matching and servicing, the broker earns a fee that is determined by competitive forces. In addition, security exchanges and the over-the-counter market improve the secondary market and hence the efficiency of the primary market where securities are sold originally.

SOLUTIONS TO PROBLEMS

1. a) Under the partnership, $418,000 in actual liabilities. If sued, they could lose up to their full combined net worths. As a corporation, their exposure is limited to the $280,000 in equity that they have in the business. b) Creditors should be less willing to extend credit, because the personal net worths of the owners no longer back the claims.

Equipment

Machine

Cost

Depreciation in year:

$28,000.00

$53,000.00

10,600.00 16,960.00 10,176.00 6,105.60 6,105.60 3,052.80

$28,000.00

$53,000.00

Payment

Percent Subject to Taxes

Amount Subject to Taxes

Taxes

Interest Pfd. Div.

$180,000 300,000

$180,000 90,000

$61,200 30,600

$91,800

4. Year

Profit

Taxes

20X1 2 0X2 2 0X3 2 0X4

(17,250) tax refund of all prior taxes paid

2 0X5

52,000

*Loss carryforward through 20X4 =

Taxable income in 20X5 = $52,000 - $17,000 = $35,000

5. a) The expected real rate of return is 5 percent, and the inflation premium is 4 percent.

b) The lender gains in that his real return is 7 percent instead of the 5 percent that was expected. In contrast, the borrower suffers in having to pay a higher real return than expected. In other words, the loan is repaid with more expensive dollars than anticipated.

c) With 6 percent inflation, the real return of the lender is only 3 percent, so he suffers whereas the borrower gains.

6. No specific solution is recommended. The student should consider default risk, maturity, marketability, and any tax effects.

SOLUTIONS TO SELF-CORRECTION PROBLEMS

1. a. Henry is responsible for all liabilities, book as well as contingent. If the lawsuit were lost, he would lose all his net assets, as represented by a net worth of $467,000. Without the lawsuit, he still is responsible for $90,000 in liabilities if for some reason the business is unable to pay them.

b. He still could lose all his net assets because Kobayashi's net worth is insufficient to make a major dent in the lawsuit: $600,000 - $36,000 = $564,000. As the two partners have substantially different net worths, they do not share equally in the risk. Henry has much more to lose.

c. Under the corporate form, he could lose the business, but that is all. The net worth of the business is $263,000 - $90,000 = $173,000, and this represents Henry's personal financial stake in the business. The remainder of his net worth, $467,000 -$173,000 = $294,000, would be protected under the corporate form.

2. Depreciation charges for the equipment:

Year Percent Amount

1

20.

00%

$ 3,

200

.00

2

32.

00

5,

120

.00

3

19.

20

3,

072

.00

4

11.

52

1,

843

.20

5

11.

52

1,

843

.20

6

5.

76

921

.60

Total

$16,

ooo

.oo

3. a. At $2 million in expenses per $100 million in loans, administrative costs come to 2 percent. Therefore, to just break even, the firm must set rates so that (at least) a 2 percent difference exists between the deposit interest rate and the mortgage rate. In addition, market conditions dictate that 3 percent is the floor for the deposit rate, while 7 percent is the ceiling for the mortgage rate. Suppose that Wallopalooza wished to increase the current deposit rate and lower the current mortgage rate by equal amounts while earning a before-tax return spread of 1 percent. It would then offer a deposit rate of 3.5 percent and a mortgage rate of 6.5 percent. Of course, other answers are possible, depending on your profit assumptions. b. Before-tax profit of 1 percent on $100 million in loans equals $1 million.

4. a. The premium attributable to default risk and lower marketability is 9% - 7.25% = 1.75%.

b. The premium attributable to maturity is 7.25% - 6% = 1.25%.

In this case, default risk is held constant and marketability, for the most part, is also held constant.

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