ACCOUNTING THEORY MGT 4160, Y- FALL 2012 ASSIGNMENT 1 Due October 23, 2012

Question 1 (10 marks) Jacob is planning to invest $100,000 for one year. There are two companies that interest Jacob but he can only invest in one of them. Jacob is a rational, risk-averse investor with utility equal to the square root of the net return on his investment. His choices are: 1. Action a1: Jacob invests $100,000 in Bikes Inc. shares. 2. Action a2: Jacob invests $100,000 in Cars Inc. shares. Jacobs payoff from these investments depends on the future price of gasoline. If the price of gasoline is high, Jacob will earn a net return of $15,000 on Bikes shares and only $4,000 on Cars shares. Alternatively, if the price of gasoline is low, Jacob will earn $10,000 on Cars shares and only $5,000 on Bikes shares. Jacobs prior probability on the price of gasoline being high is 35%. Required a) Determine which action Jacob should take based on his prior probabilities. Show calculations (3 marks). b) After undertaking extensive research, Jacob determines that gasoline refiners are expecting good news. That is, gasoline refiners expect the price of gasoline to be high. Jacob has determined that if future gasoline prices are going to be high, there is an 80% probability that gasoline refiners will expect good news. Alternatively, if future gasoline prices are going to be low there is a 30% probability that gasoline refiners will expect good news. Provide the information system, using a 2 2 matrix that depicts this new information (4 marks). c) Since gasoline refiners are expecting good news, determine whether Jacob should invest in Bikes or Cars. Show your calculations (3 marks).

MGT 4160 Accounting Theory

Fall 2012

Question 2 (10 marks) Knowing that you are attending an accounting theory course, your friends Bill and Scott approach you for some advice on investing. They have very different ideas about investing and are hoping you can settle some arguments they are having about how rational investors behave. Required a) Indicate the usual assumption about the risk preferences of rational investors. Explain to Bill and Scott why this is the usual assumption (3 marks). b) Bill and Scott are intrigued by your explanation of risk preferences and they want to learn more. Bill recounts that his father was an egg farmer, and for any problem in life his fathers only answer was, Son, dont put all your eggs in one basket. Bill wants to know whether this down-to-earth wisdom might apply to investing. Explain how this idea applies to investing (3 marks). c) Scott surprises you by asking the following: I was looking at your accounting theory notes the other day, and I saw references to states of nature and factors that affect share returns. You explain to Scott that the three factors are market-wide factors, industry-wide factors, and firm-specific factors. Indicate two examples for two of the factors listed above (4 marks).

Question 3 (10 marks) On February 15, 2011, ProCorp Inc. announced that its EPS for the next quarter is expected to increase to 45 cents per share. ProCorp also released its financial results for the year ended December 31, 2010 on the same date. The earnings per share in the prior quarter (ended December 31, 2010) were 17 cents per share, exactly what analysts had forecasted for that quarter. ProCorp supported its forecast about the next quarter by pointing out the success of its new product launch and favourable product acceptance rates in new markets. At the end of trading on February 14, 2011, ProCorps shares had increased 30% for the year to date. On February 15, 2011, ProCorps shares opened the day on the stock exchange at $36 and closed at $41. The stock exchange index increased 37 points on the day to close at 9,715. ProCorps beta is 1.9 and the Bank of Canada rate on February 15, 2011 was 4.5%, or about 0.0001 per day. Required a) Calculate the abnormal return of ProCorps shares for February 15, 2011. (Use the market model for abnormal returns and use CAPM for calculating ) (4 marks)

MGT 4160 Accounting Theory

Fall 2012

b) Assuming the securities market is efficient, explain why ProCorps share price increased on February 15, 2011. (2 marks) c) Identify and explain two assumptions about individual investors that underlie the CAPM. (4 marks)

Question 4 (20 marks) Choose one of the following videos available from www.youtube.com and write a review paper, 1,000 to 1,200 words (5 to 6 pages using a size 11 font, double spaced). Your review should include the following elements: i A title that appropriately summarizes the content of the video ii Summary of key points presented in the video (400-500 words) iii How the contents of the video relate to accounting theory (250-300 words) iv Your thoughts about the key points summarized above (350-400 words) Akerkof: http://www.youtube.com/watch?v=HFpEbtrV8Ec Siegel: http://www.youtube.com/watch?v=8mT-JOqTIMk Schiller: http://www.youtube.com/watch?v=8RrKScRg5KM Barberis: http://www.youtube.com/watch?v=gh_EbIPcnSk Kahneman: http://www.youtube.com/watch?v=3CWm3i74mHI

MGT 4160 Accounting Theory

Fall 2012