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Question 1 (15 marks)

Efficient securities market theory has long been under attack from behavioural finance, which draws on behavioural theories of investor behaviour to explain why security prices do not always behave as the economic theories of rational investing and market efficiency predict. These attacks have increased since the 2007-2008 security market meltdowns.

Required

a. (4 marks)

Explain why prospect theory predicts that security prices will differ from their prices under efficient security markets theory.

b. (4 marks)
Describe two accounting-related efficient securities market anomalies and, for each, explain why it is an anomaly.

c. (3 marks)
The efficient securities market anomalies suggest that investors underreact to the full information content of financial statements. Choose one behavioural theory that predicts this underreaction and explain

 

why it predicts underreaction.

d. (4 marks)
Should accountants be concerned that the importance of financial reporting may decline if behaviourally biased investors do not use all the information in the financial statements? Explain.

Question 2 (17 marks)

HiSpeed Ltd. plans to manufacture cross-country skiing equipment. Its cash flows are highly dependent on the weather in early winter. HiSpeed operates under ideal conditions of uncertainty. On August 1, 2014, the beginning of its first year in business, HiSpeed acquires equipment to be used in its operations. The equipment will last two years, at which time its salvage value will be zero. The company finances the equipment purchase by issuing common shares.

HiSpeed’s annual net cash flows will be $800 if the weather is snowy and $300 if it is not snowy. Assume that cash flows are received at year end. In each year, the objective probability that the weather is snowy is 0.7 and 0.3 that it is not snowy. The interest rate in the economy is 3% in both years.

HiSpeed will pay a dividend of $50 at the end of each year of operation.

Required

a. (9 marks)
In 2014, the weather is snowy. Prepare a statement of financial position as at July 31, 2015, the end of HiSpeed’s first year of operations, and an income statement for the year. 

b. (2 marks)

What timing of revenue recognition is implicit in the income statement you have prepared in part (a)? When ideal conditions do not hold, is this timing of revenue recognition relevant? Is it reliable? Explain. 

c. (6 marks)  
Assume that HiSpeed paid the present value you calculated in part (a) for its equipment. Calculate HiSpeed’s net income for the year ended July 31, 2015 on a historical cost basis, assuming that equipment is depreciated on a straight-line basis. Under the more realistic assumption that ideal conditions do not hold, which measure of net income is most relevant? Which is most reliable? Why?          

Question 3 (18 marks)

Prem has $2,000 that he wishes to invest for one year. He has narrowed his choices down to one of the following two actions:

i: Buy bonds of X Ltd., a company that has a very high debt-to-equity ratio. These bonds pay 8% interest, unless X defaults, in which case Prem will receive no interest but will recover his principal. (a1)

ii: Buy Canada Savings Bonds, paying 3% interest. (a2)

Prem assesses the prior probability of X Ltd. defaulting as 0.40. His utility for money is given by the square root of the amount of his net payoff. That is, if he buys the Canada Savings Bonds, his net payoff is $60, yielding utility of √60 = 7.75, and so on. Prem is a rational decision maker.

Required

a. (4 marks)
Based on his prior probability calculations, which action should Prem take? Show your calculations. 

b. (9 marks)
Before making a final decision, Prem decides he needs more information. He obtains X Ltd.’s current financial statements and examines its times-interest-earned ratio. This ratio can be either high or low. Upon calculating the ratio, Prem observes that it is low. On the basis of his prior experience in bond investments, Prem knows the following conditional probabilities: 

0.50

	Debt-to-Equity Ratio
Future State	Low	High
ND (no default)		0.50
D (default)	0.05	0.95

Which action should Prem take based on this new information? Show your calculations; take each step to two decimal places.

c. (5 marks)
An accounting standard (IAS 16) allows X Ltd. to value its property, plant, and equipment at fair value. The company plans to adopt this option, since it will reduce its debt-to-equity ratio.

Evaluate (in words — no calculations required) the likely impact of this adoption on the main diagonal probabilities of the information system in part (b).