Chapter 6_Solutions

Chapter 6_Solutions - Suggested Solutions to Assigned...

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Suggested Solutions to Assigned Problems in Chapter 6: 4, 5, 6, 13 4. The efficient market will respond more strongly to the GN or BN in earnings (i.e., a higher ERC) the greater is the persistence of the GN or BN. Cash flows are more persistent than accruals since the effects of accruals on current earnings reverse in future periods, whereas (operating) cash flows are not subject to this reversal phenomenon. Sloan checked this argument for his sample firms and found that cash flows were indeed more persistent than accruals. This being the case, the efficient market will respond more strongly to a dollar of abnormal earnings if it comes from operating cash flows than if it comes from accruals (recall that net income equals operating cash flows plus or minus net accruals). Sloan found that while the market did respond to the GN or BN in earnings, it did not respond more strongly when there was a greater proportion of cash flows to accruals in earnings . This is an anomaly because a differential response is predicted by efficient securities market theory. 5. According to rational single-person decision theory, the investor will prefer the first fund, since it has both a higher expected return and a lower risk. According to prospect theory, however, investors will separately evaluate gains and losses on their investment prospects, and the rate of decrease of utility for small losses may be considerably greater than the rate of increase of utility from small gains. Since the second fund truncates the fund losses, this gives it an advantage over the first fund. Also, under prospect theory, investors may underweight probabilities of states that are likely to happen, as a result of overconfidence bias, and overweight probabilities of states that are unlikely to happen, due to representativeness bias. The probability of a gain (a state realization) on the first fund is high relative to the probability of a gain on the
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This note was uploaded on 12/14/2010 for the course ACC 706 taught by Professor Shadifarshad during the Winter '09 term at Ryerson.

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Chapter 6_Solutions - Suggested Solutions to Assigned...

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