Frank, a rational investor, has $2,000 to invest for one yearwhile she completes her professional accounting designation. She iscontemplating investing the full amount in shares of Northern Oil& Gas Ltd. (a1) or in a risk-free government bond yielding anannual return of 3.2% (a2). Frank identifies two states ofnature:
State H: Northern has high future cash flow.
State L: Northern has low future cash flow.
On the basis of her prior information about Northern, Frankassesses the following subjective prior state probabilities:
State H: 0.4
State L: 0.6
The following is the payoff table for these two investments.Payoffs from Northern shares include dividends and estimatedcapital gain for the year. Capital gain is based on the averageanalyst forecast for Northernâs share price. Payoffs are net of(i.e., they exclude) the original investment.
STATE H L ACT A1 484 25 ACT A2 64 64
The investor is risk adverse, with utility equal to the squareroot of the net dollar payoff.
a. On the basis of her prior probabilities, which act shouldFrank take? Show calculations.
b. Instead of acting now, Frank decides to obtain more aboutNorthern by reading its annual report. He knows that financialstatements are based on a mixed measurement model. Also, he is astudent of financial accounting theory, and estimates the qualityof financial statements prepared according to these standards bythe following information system:
GOOD BAD H 0.7 0.3 L 0.1 0.9
Good evidence means that a company reports profits that arehigher than the average analyst forecast. Bad evidence means thatthe companyâs profits are less than forecast.
Upon reading the current annual report, Frank finds it is good.Which act should Frank take now? Show calculations.
C. After buying Northern shares, Frank is disappointed to notethat the market price of its shares begins to fall, despite thegood news in its earnings report. She now suspects that the goodnews in Northernâs financial statements was not as good as sheoriginally believed. Is this possible? Give reasons why or whynot.
Frank, a rational investor, has $2,000 to invest for one yearwhile she completes her professional accounting designation. She iscontemplating investing the full amount in shares of Northern Oil& Gas Ltd. (a1) or in a risk-free government bond yielding anannual return of 3.2% (a2). Frank identifies two states ofnature:
State H: Northern has high future cash flow.
State L: Northern has low future cash flow.
On the basis of her prior information about Northern, Frankassesses the following subjective prior state probabilities:
State H: 0.4
State L: 0.6
The following is the payoff table for these two investments.Payoffs from Northern shares include dividends and estimatedcapital gain for the year. Capital gain is based on the averageanalyst forecast for Northernâs share price. Payoffs are net of(i.e., they exclude) the original investment.
| STATE | |||
| H | L | ||
| ACT | A1 | 484 | 25 |
| ACT | A2 | 64 | 64 |
The investor is risk adverse, with utility equal to the squareroot of the net dollar payoff.
a. On the basis of her prior probabilities, which act shouldFrank take? Show calculations.
b. Instead of acting now, Frank decides to obtain more aboutNorthern by reading its annual report. He knows that financialstatements are based on a mixed measurement model. Also, he is astudent of financial accounting theory, and estimates the qualityof financial statements prepared according to these standards bythe following information system:
| GOOD | BAD | ||
| H | 0.7 | 0.3 | |
| L | 0.1 | 0.9 |
Good evidence means that a company reports profits that arehigher than the average analyst forecast. Bad evidence means thatthe companyâs profits are less than forecast.
Upon reading the current annual report, Frank finds it is good.Which act should Frank take now? Show calculations.
C. After buying Northern shares, Frank is disappointed to notethat the market price of its shares begins to fall, despite thegood news in its earnings report. She now suspects that the goodnews in Northernâs financial statements was not as good as sheoriginally believed. Is this possible? Give reasons why or whynot.
