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14-1. What are financial markets? What function do they perform? How would an
economy be
worse off without them?
Financial markets are institutions and procedures that facilitate transactions in all
types of
financial claims. Financial markets perform the function of allocating savings in the
economy to the ultimate demander(s) of the savings.
markets, the
Without these financial
total wealth of the economy would be lessened. Financial markets aid the rate of
capital
formation in the economy.
14-3. Distinguish between the money and capital markets.
The money market consists of all institutions and procedures that accomplish
transactions
in short-term debt instruments issued by borrowers with (typically) high credit
ratings.
Examples of securities traded in the money market include U.S. Treasury Bills,
bankers’
acceptances, and commercial paper. Notice that all of these are debt instruments.
Equity
securities are not traded in the money market. It is entirely an over-the-counter
market.
On the other hand, the capital market provides for transactions in long-term
financial
claims (those claims with maturity periods extending beyond one year). Trades in
the
capital market can take place on organized security exchanges or over-the-counter
markets.
14-4. What major benefits do corporations and investors enjoy because of the existence
of organized security exchanges?
Organized stock exchanges provide for:
(1)
A continuous market. This means a series of continuous security
prices is generated. Price changes between trades are dampened,
reducing price volatility, and enhancing the liquidity of securities.
(2)
Establishing and publicizing fair security prices. Prices on an
organized exchange are determined in the manner of an auction.
Moreover, the prices are published in widely available media like
newspapers.
(3)
An aftermarket to aid businesses in the flotation of new security
issues. The continuous pricing mechanism provided by the exchanges
facilitates the determination of offering prices in new flotations. The
initial buyer of the new issue has a ready market in which he can sell
the security should he need liquidity rather than a financial asset.
15-5A (Leverage analysis) You have developed the following analytical income
statement for your corporation. It represents the most recent year’s operations, which
ended yesterday. Sales $45,750,000 Variable costs __2_2_,8_0_0_,_0_0_0 Revenue
before fixed costs $22,950,000 Fixed costs ___9_,2_0_0_,_0_0_0 EBIT $13,750,000
Interest expense ___1_,3_5_0_,_0_0_0 Earnings before taxes $12,400,000 Taxes (.50)
___6_,2_0_0_,_0_0_0 Net income __$____6__,2__0__0__,__0__0__ Your supervisor in
the controller’s office has just handed you a memorandum asking for written responses to
the following questions: a. At this level of output, what is the degree of operating
leverage? b. What is the degree of financial leverage? c. What is the degree of combined
leverage? d. What is the firm’s break-even point in sales dollars? e. If sales should
increase by 25 percent, by what percent would earnings before taxes (and net income)
increase? e.
a.
Revenue Before Fixed Costs
EBIT
=
$22,950,000
$13,750,000
=
1.67
times
b.
EBIT
EBIT  I
=
$13,750,000
$13,750,000  $1,350,000
=
$13,750,000
$12,400,000
times
c.
DCL 45,750,000 = (1.67) (1.11) =
d.
S*
=
F
VC
1
S
=
$9,200,000
$22,800,000
1
$45,750,000
1.85 times
=
$9,200,000
1  .498
= 1.11
=
e.
$9,200,000
= $18,326,693.23
.502
(25%) (1.85)
= 46.25%
15-9A (Fixed costs and the break-even point) A & B Beverages expects to earn $50,000
next year after taxes. Sales will be $375,000. The store is located near the shopping
district surrounding Blowing Rock University. Its average product sells for $27 a unit.
The variable cost per unit is $14.85. The store experiences a 40 percent tax rate. a. What
are the store’s fixed costs expected to be next year? b. Calculate the store’s break-even
point in both units and dollars.
(a)
{S- (VC + F)} (1-T) = $50,000

S 

  VC 

S  S   F  1  T  = $50,000

 

[S – VC - } (1 – T) = $50,000
{$375,000 - $206,250 – F} (0.6) = $50,000
($168,750 - F) (0.6) = $50,000
F = $85,416.67
(b)
F
PV
QB =
S* =
F
VC
1
S
=
=
$85,416.67
$85,416.67
=
= 7,030 units
$27.00  $14.85
$12.15
$85,416.67
= $189,815
1  .55
15-13A (Break-even point and operating leverage) Allison Radios manufactures a
complete line of radio and communication equipment for law enforcement agencies. The
average selling price of its finished product is $180 per unit. The variable cost for these
same units is $126. Allison Radios incurs fixed costs of $540,000 per year. a. What is the
break-even point in units for the company? b. What is the dollar sales volume the firm
must achieve in order to reach the break-even point? c. What would be the firm’s profit
or loss at the following units of production sold: 12,000 units? 15,000 units? 20,000
units? d. Find the degree of operating leverage for the production and sales levels given
in
a)
QB
=
(b)
S*
=
F
$540,000
$540,000
=
=
= 10,000 units
PV
$180  $126
$54
$540,000
$540,000
F
$540,000
=
=
=
VC
$126
1  0 .7
.3
1
1
S
$180
= $1,800,000
(c)
(d)
Sales
Variable costs
Revenue before fixed costs
Fixed costs
12,000
Units
$2,160,000
1,512,000
$ 648,000
540,000
15,000
Units
$2,700,000
1,890,000
$ 810,000
540,000
20,000
Units
$3,600,000
2,520,000
$1,080,000
540,000
EBIT
$ 108,000
$ 270,000
$ 540,000
12,000 units
$648,000
= 6 times
$108,000
15,000 units
$810,000
= 3 times
$270,000
20,000 units
$1,080,000
= 2 times
$540,000
Notice that the degree of operating leverage decreases as the firm's sales
level rises above the break-even point.