Tina has $3,000 that she wishes to invest for one year. She has narrowed her choices down
Question:
Tina has $3,000 that she wishes to invest for one year. She has narrowed her choices down to one of the following two actions:
a1: Buy bonds of Risky Mining Ltd. The se pay 14.7% interest unless Risky goes bankrupt, in which case Tina will lose her principal and interest.
a2: Buy savings bonds, paying 6.2% interest.
Tina assesses her prior probability of Risky Mining Ltd. going bankrupt as 0.40. The savings bonds will pay off regardless of whether Risky goes bankrupt or not. Tina's utility for money is given by the square root of the amount of her gross payoff. That is, if she buys the savings bonds her gross payoff is $3,186, etc. Tina is a rational decision maker.
Required
a. Based on her prior probabilities, which action should Tina take? Show your calculations.
b. Before making a final decision, Tin a decides she needs more information. She obtains Risky Mining's current financial statements and examines its debt-equity ratio. This ratio can be either " HI" or "LO." Upon calculating the ratio, Tina observes that it is LO. On the basis of her prior experience in bond investments, Tina knows the following conditional probabilities:
Which action should Tina now take? Show your calculations, taken to two decimal places.
c. A new accounting standard requires that Risky Mining Ltd.'s pension liabilities must now be measured in the financial statements at their expected discounted present values (i.e., value in use), instead of the previous pay-as-you-go accounting under which pension expense was based on amounts paid out for pensions during the period with no balance sheet liability recorded.
Evaluate (in words only) the likely impact of the new standard on the main diagonal probabilities of the information system in part b.
Step by Step Answer:
Financial Accounting Theory
ISBN: 9780134166681
8th Edition
Authors: William R. Scott, Patricia O'Brien