14-1

Solutions Guide: Please reword14-1. 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. Without these financial markets, the

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 years 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 controllers 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 firms 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.

=

=1.67 times

b.

=

=

=1.11 times

c.DCL 45,750,000=(1.67) (1.11)=1.85 times

d.S*=

=

=

=

=$18,326,693.23

e.(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 stores fixed costs expected to be next year? b. Calculate the stores break-even point in both units and dollars.

(a){S- (VC + F)} (1-T) = $50,000

= $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)QB = = = = 7,030 unitsS* = = = $189,815

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 firms 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 ina)QB =

= = = 10,000 units

(b) S* =

= = =

=$1,800,000

(c)

12,00015,00020,000

Units UnitsUnits

Sales$2,160,000$2,700,000$3,600,000

Variable costs1,512,0001,890,0002,520,000

Revenue before fixed costs$ 648,000$ 810,000$1,080,000

Fixed costs540,000540,000540,000

EBIT$ 108,000$ 270,000$ 540,000

(d)12,000 units15,000 units20,000 units

= 6 times

= 3 times

= 2 times

Notice that the degree of operating leverage decreases as the firm's sales level rises above the break-even point.

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