Question

Evaluate the appropriateness of the following statements by using the principles of finance:

1. CompanyZ’s profit has been decreasing for the past 2 years, so the management decided to engage in earnings management practice by changing their accounting policy which resulted in current year’s profit increase but no effect to the company’s future cash flows. In an efficient market, the stock price of company Z will increase

   as a result of profit increase.

2. When making investment decisions, Bobby always looks at the company’s profit as

   stated in the income statement, as he believes that it is profit (which is determined

   by accrual basis) that determines the value of a company.

3. Stephanie just won the lottery and she has 2 options: to receive the lottery prize money of $50,000 today or to receive it $10,000 each year for the next 5 years. Stephanie thinks that she would be indifferent as to which option she will take,

   because the total amount of money is still $50,000.

4. Cindy puts her money in an investment which is considered risk-free, hence she is

   not expecting any return from her investment.

Answer 1

1. Markets are regarded as efficient when all the available information is incorporated into the stock prices. Earnings management refers to window dressing the financial statements or manaipulating the financial results to show positive income in the short term. So the informationn regarding manipulation of data is not a publicly available information. This means that these markets have a semi strong efficiency. In a semi strong efficient market, the stock prices will adjust to the publicly available information that profits have increased. So this is true.

2. Accrual basis of accounting is a more transparent method of accounting than cash accounting. Accrual basis of accounting records tranasactions as and when they occur unlike cash accounting where the transactions are recorded when cash is actually received or paid out. Bobby is right in looking at the company’s profit as stated in the income statement, as it is profit (which is determined by accrual basis) that determines the value of a company. So this is true.

3. As per the concept of time value of money, money received today has more value than money received later. As inflations costs reduce the value of money overtime. So a 50000 $ lumpsum is worth much more than a 10000$ 5 year annuity. If we consider the interest rate as 1% also, the 10000 $ over 5 years is only valued at 48,534.31 $ today. So this is false i.e. you cannot be indifferent to the money received today or later.

4. A risk free instrument does not mean that the investor will not receive any return. It means that risk-free rate is the minimum return an investor expects for any investment because they are not willing to take up additional risk unless the return is more than the risk free rate. So this is false.