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Unformatted text preview: Solution to supplementary problems – Chapter1
P1-1. Suggested solution:
People need to make decisions under uncertainty, which creates the demand for information to
reduce that uncertainty, allowing them to make better decisions. However, if everyone had
access to the same information at the same time, no one would be able to supply any information
useful to anyone else (since they already have it). Thus, an asymmetric distribution of
information is necessary for the supply of information from those who have relatively more of it
to those who have relatively less.
P1-3. Suggested solution:
A borrowing/lending transaction involves an advance of funds from the bank to the company in
exchange for promises of future repayment from the company to the bank. There is, of course,
uncertainty regarding the ability of the company to repay the bank in the future. The
corporation’s management has better information about the company’s prospects in comparison
to bank staff. To reduce this information asymmetry, the bank demands information such as
audited financial statements. The corporation is willing to supply this information in order to
obtain the most favourable borrowing terms (e.g., a low interest rate).
P1-5. Suggested solution:
This is a case of adverse selection, because the information is not affected by the actions of the
person who has the information—we cannot change time. There is only hidden information, not
hidden actions. (Using a fake or borrowed piece of identification is fraudulent and the insurance
would be voided.)
P1-6. Suggested solution:
Version A of the game involves only uncertainty; the information is symmetrically distributed
among all three participants in the game. While there is a demand for information about the
value of the drawn card, there is no information for anyone to supply to anyone else. In this
scenario (and assuming “risk neutrality”), the rational bids start at $1 and go no higher than
$5.50, the latter being the expected value of the card. Bids higher than $5.50 will lose money on
average. While the lowest bid of $1 provides you with the most profit, competition from Julia
forces you to successively increase your bid, so we expect the equilibrium final bid to be $5.50.
Version B of the game involves both uncertainty and information asymmetry. Scott has more
information than you and Julia, so he can supply you with information if it is in his best interest
to do so. In this game, your best strategy is to bid $1 and to make higher bids only if Scott
provides information that indicates the card has a higher value. Since Scott’s income depends on
how much you and Julia bid, and his cost equals the value of the card, it is in his interest to
provide as much information as possible so that the bids are as high as possible. (Scott’s
disclosures about the card must be truthful because they can be verified against the card at the
end of the game.) For example, if the card is a seven of hearts, Scott can say any of the
following: “the card has hearts,” which is true but not useful; “the card is higher than three,”
which is true; “the card is at least six,” which is also true. Since you and Julia increase your bids
according to the information that Scott provides, ultimately he is forced to say something that Chapter 1 1 of 3 Fundamental of financial accounting theory reveals the card’s value of seven. This is the full-disclosure outcome in adverse selection. There
is no moral hazard because there is nothing that Scott can do to change the value of the card that
P1-8. Suggested solution:
The fundamental issue is whether equity financing (in addition to debt) is a good idea.
The writer does not recognize the importance of moral hazard in his proposal.
From the student’s perspective, equity financing reduces the rewards of hard work
Conversely, the cost of not working hard is partly borne by investors.
The risks to the student are also reduced.
Therefore, the incentives to make money are reduced.
The effect is much like that of a tax on income.
Debt imposes more risk on students so students have more incentive to earn money.
Equity contracts may lead to misreporting of income during the contract period.
Students may engage in pay-deferral arrangements when they start working.
Students will tend to self-select the type of financing.
o Better students and those willing to work harder will choose the debt contract.
o Other less able students will choose the equity contract.
o Therefore, the cost of the equity contracts may be very high.
Unlike corporations, if the investors do not like how the student is behaving (i.e., not earning
money), they cannot fire the management.
Again, investors will anticipate this, and demand a high rate of return from the student before
Will there be sufficient information available to price the human capital contracts?
Equity contracts for different groups of students may offer different rates/returns.
o For example, business and medical students vs. others, male/female, different universities
o May lead to perception of bias if financial institutions charged different rates to different
P1-10. Suggested solution:
The incentive plan is based on a measure of performance that is not consistent with
Shareholders are interested in the stock price and the amount of profit available to them.
Incentive plans based on stock price or return on equity would be most appropriate from
the shareholders’ perspective.
Changes in ROA and ROE are closely related if leverage remains stable.
Using the definition of operating profit margin and ROA, we can infer that turnover =
sales / total assets = ROA / op. profit margin = 4.4% / 5.5% = 0.8 (in 2010) vs. 1.23
(2009) and 1.25 (2008).
ROA has further declined in 2010 even though profit margin has increased because
turnover has declined.
The incentive plan prompted management to maximize profit margin while sacrificing
The lower turnover is partly explained by the rise in A/R by roughly half as a proportion
of sales. Chapter 1 2 of 3 Fundamental of financial accounting theory *
* Possibly looser credit policies have been put in place to increase sales without lowering
The theory of efficient security markets suggests that QAF’s stock price reflects valuedestroying behaviour.
If this were a manufacturer, absorption costing and overproduction could increase profits
and reduce turnover.
Macroeconomic factors could also be affecting ROA and the stock price. P1-12. Suggested solution:
The theory of efficient security markets (EMH) applies to commodities as much as to
Investors cannot make superior returns consistently if the markets are efficient.
It is probably more difficult to “spot the home-run play” in the commodities market—
there are many more buyers and sellers for each commodity (only 20 commodities) than
in the stock market.
Basic economics tells us that commodity markets, having many buyers and sellers, are
There could be more risk in commodities, explaining the higher returns. Systematic risk
could be higher—many commodity prices move together because of weather and the
If the brochure provides inside information, you could make superior profits. However,
this brochure is widely circulated, and if many others have already bought into this
system there is unlikely to be any inside information left.
P1-13. Suggested solution:
In response to the friend studying liberal arts:
Opening price reflects expectations before the earnings announcement.
Those expectations incorporate more information than just the previous earnings report.
Non-accounting information led investors to expect earnings to be higher than what was
It is unlikely that MLF’s price is inefficient because its shares are traded so heavily.
The restructuring charges included in the announcement could signal bad news about
The presence of restructuring charges could also lead to more suspicion about the
reliability of earnings before restructuring charges, decreasing confidence in the
In response to the friend studying finance:
Movement in stock price after the announcement shows that accounting information is
useful. If accounting information were not useful, why did the stock price change so
Direction of the price change depends on whether the announcement was good news or
bad news relative to expectations, not past accounting numbers.
It is also possible that there were other news releases in the day affecting the price. Chapter 1 3 of 3 Fundamental of financial accounting theory ...
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- Winter '10