28 PART 1 Introduction to Managerial Finance
ordinary income
Income earned through the sale
of a firm’s goods or services.
LG6Suppose, for example, that the firm shown in Figure 1.5 announces a favorable
discovery. Investors expect rewarding results from the discovery, so they increase
their valuations of the firm’s shares. The changing evaluation results in a shift in
demand from D 0 to D 1. At that new level of demand, Q 1 shares will be traded,
and a new, higher equilibrium price of P 1 will result. The competitive market cre-
ated by the major securities exchanges provides a forum in which share price is
continuously adjusted to changing demand and supply.Review Questions
1–18 Who are the key participants in the transactions of financial institutions?
Who are net suppliers and who are net demanders?
1–19 What role do financial marketsplay in our economy? What are primary
and secondarymarkets? What relationship exists between financial insti-
tutions and financial markets?
1–20 What is the money market?How does it work?
1–21 What is the Eurocurrency market?What is the London Interbank Offered
Rate (LIBOR)and how is it used in this market?
1–22 What is the capital market?What are the primary securities traded in it?
1–23 What role do securities exchanges play in the capital market? How does
the over-the-counter exchangeoperate? How does it differ from the orga-
nized securities exchanges?
1–24 Briefly describe the international capital markets, particularly the
Eurobond marketand the international equity market.
1–25 What are efficient markets?What determines the price of an individual
security in such a market?1.5 Business Taxes
Taxes are a fact of life, and businesses, like individuals, must pay taxes on
income. The income of sole proprietorships and partnerships is taxed as the
income of the individual owners; corporate income is subject to corporate taxes.
Regardless of their legal form, all businesses can earn two types of income: ordi-
nary and capital gains. Under current law, these two types of income are treated
differently in the taxation of individuals; they are not treated differently for enti-
ties subject to corporate taxes. Frequent amendments in the tax code, such as the
Economic Growth and Tax Relief Reconciliation Act of 2001(reflected in the
following discussions), make it likely that these rates will change before the next
edition of this text is published. Emphasis here is given to corporate taxation.Ordinary Income
The ordinary incomeof a corporation is income earned through the sale of goods
or services. Ordinary income is currently taxed subject to the rates depicted in the
corporate tax rate schedule in Table 1.4.