X Ltd. is a growth firm that uses very conservative accounting policies. Y Ltd. is growing more slowly and uses fair value accounting for its capital assets and related amortization. Otherwise, X Ltd. and Y Ltd. are quite similar. They are the same size and have similar capital structures and similar betas.
a. Both X Ltd. and Y Ltd. report the same GN in earnings this year. Which firm would you expect to have the greater security market response (ERC) to this good earnings news? Explain.
b. Suppose that X Ltd. had a much higher debt– equity ratio and beta than Y Ltd. Would your answer to part a change? Explain.