Assignment 1 for Aifarooq

Question 2 (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

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

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

1. (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).

Question 3 (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

1. (4 marks)

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

2. (4 marks)Describe two accounting-related efficient securities market anomalies and, for each, explain why it is an anomaly.

3. (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.

4. (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.

50