Supplymentary Chapter 1

Supplymentary Chapter 1 - Solution to supplementary...

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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 was drawn. 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 investing. 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 groups. P1-10. Suggested solution: * The incentive plan is based on a measure of performance that is not consistent with shareholders’ goals. * 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 turnover. * 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 prices. 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 stocks. * 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 nearly perfect. * 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 economic cycle. * 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 reported. * 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 future operations. * The presence of restructuring charges could also lead to more suspicion about the reliability of earnings before restructuring charges, decreasing confidence in the company. 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 much? * 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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