Question: Behavioural factors and noise trading can distort a firm s share

Behavioural factors and noise trading can distort a firm’s share price. As a result, man-agers of some firms may find their firms undervalued by the capital market relative to their inside information. The question then is, how can they best signal the real value of the firm?
Healy and Palepu (HP; 1993) provided an illustration of what managers might do in response to this question. Patten Corporation 32 acquires large undeveloped tracts of land, subdivides them into lots, and sells them, with up to 90% of the financing supplied by Patten. Revenue is recognized upon sale—that is, when at least 10% of the purchase price has been received and collection of the balance is reasonably assured. This creates a potential problem of bad debt losses. However, in its 1986 financial statements, Patten provided a bad debt allowance of only $ 10,000 on accounts receivable of $ 29.4 million. The firm claimed that this low amount was justified by past experience and a low current delinquency rate.
However, concern appeared in the financial media that Patten’s bad debt allowance was too low. Specifically, the fear was expressed that past delinquency rates may not be representative of future delinquency. Patten’s share price plunged following the publication of these concerns, as investors quickly revised their beliefs about Patten’s future performance.
Patten’s management reviewed its procedures for estimating doubtful accounts and concluded that the $ 10,000 allowance was reasonable. As a result, management felt that the media article resulted in substantial undervaluation of the company’s shares.

a. Suggest three signals that management could use to convince the market of this undervaluation. For each signal, explain why the signal is credible.
b. Which of your three signals would you recommend to Patten’s management? Explain why. Your recommendation criteria should include incurring the lowest cost of releasing proprietary information.

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  • CreatedSeptember 09, 2014
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