Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual

Chapter 2: The Business, Tax, and Financial Environments
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 would 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. Lower the coupon rate, greater
the price volatility of a bond, and all other things being the same, generally higher the yield.
TESTBANKEDUCATION.COM
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
14