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AC3103: SEMINAR 3

5-8. XYZ Ltd is a large retail company listed on a major stock exchange
and its reported net income for the year ended 31 December 2015 is
$5m. The earnings were announced to the public on 31 March 2016.
Financial analysts had predicted the companys net income for 2015 to
be $7m. The financial analysts prediction was in effect up until the
release of the 2015 earnings on 31 March 2016.
Assumptions:
1. No other news about XYZ Ltd was released to the public on 31
March 2016.
2. No significant economy-wide events affecting share prices
occurred on 31 March 2016.
Required
a. Would you expect a change in price of XYZ Ltds common stock on
31 March 2016? If so, why?
Yes, a stock price decrease is expected, other things equal, because
unexpected earnings were negative $2 million. This conveys bad news to
the market. Security prices should react negatively to this information.
b. Consider the 2 situations below:
i.
The deviation of forecasted earnings from actual earnings of
$2m is completely accounted for by the closing down of a
number of its retail outlets.
ii.
The deviation of the forecasted earnings from actual
earnings is completely accounted for by a fire in XYX Ltds
largest retail outlet, which had caused the outlet to be
closed temporarily for 6 months.
In which of these 2 scenarios would you expect the price change
of XYZ Ltds common stock to be greater? Explain.
The share price decrease should be greater for scenario (i) because that
situation reflects a persistent decline in earnings arising from shutdown of
a number of retail outlets. In scenario (ii), the earnings decrease is
transitory. Hence, XYZs common stock price change should be greater in
scenario (i).
c. Suppose instead that significant economy-wide events on 31
March 2016 resulted in a major increase in the stock market
index. Would this affect your answer in part a? Explain.
Yes. If economy-wide events were such that the whole market rose
strongly on December 31, this could overwhelm the bad firm-specific
information, and XYZs share price would rise. Other information released
at the same time as the earnings announcement could produce a share
price rise despite the bad earnings news. Such information could include
strong balance sheet fundamentals (assuming balance sheet information
is available at this time) and/or optimistic management forecasts of future
firm prospects.

5-10. 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 and Y Ltd are
quite similar. They are the same size and have similar capital structure
and similar betas.
Required:
a. Both X 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 earning news? Explain.
X Ltd. would be expected to have a higher ERC. First, it uses high quality
accounting policies. Consequently, a given dollar of GN has higher
implications for future profitability and returns than for Y Ltd. In effect, the
main diagonal probabilities of the information are higher for X than for Y
because of its higher earnings quality. Second, Ys reported net income
may have lower reliability than X because it uses current value accounting
for its capital assets. Readily available and well-working market values
may not exist for capital assets, and alternative current value estimates
may lack reliability due to the large number of estimates that are required
and the possibility of bias. The market would be less responsive to
unreliable information, other things equal. Third, X Ltd. is a growth firm.
Theory and evidence exists that firms with growth opportunities have
higher ERCs than non-growth firms.
a. Suppose that X Ltd had a much higher debt-to-equity ratio and
beta than Y Ltd. Would your answer to part a change? Explain.
The answer could change, because firms with higher debt to equity ratios
and betas tend to have lower ERCs. If these effects are strong enough to
outweigh the effects in part a, the ERC would be lower for X Ltd.
5-12. IAS 1 recognises the need for full disclosure of the components of
reported net income. Explain why full disclosure of net income
components is important for investors are to properly interpret the
implication of current reported net income for future firm performance.
What is classification shifting? Why does classification shifting make it
more difficult for investors to predict future firm performance from
current reported net income? How could the problem of classification
shifting be reduced?
Evaluation of earnings persistence is a particular problem when the firm has low
persistence items such as non-recurring or unusual items of gains or losses.
Unless these items are fully disclosed, investors may regard them as persistent
when, in fact, they are not. Classification shifting is the deliberate
misclassification of items within income statement to increase core earnings.
(form of earnings management)
To make matters worse, current low persistence items might increase future core
earnings, and these effects are not disclosed. This is a particular problem if the
initial write-offs are excessive. This will decrease the usefulness of financial
statements for investors.

5-17 On 8 May 2001, the Financial post reported The street turns
against Canadian Tire. Canadian Tire Corporation Ltds share price had
risen by $0.75 to $24.90 on May 2 2001, following a news release in
which Wayne Sales, president and CEO at the time, said, We are
pleased with our ability to deliver double digit growth Canadian
Tires reported earnings of $0.37 per share exceeded analysts
expectations.
The market soon learned, however, that reported earnings included an
$8m one-time gain on sale of certain Canadian Tire assets. Without this
gain, earnings were $0.29 per share, 6% below earnings for the same
quarter of 2000. Canadian Tires share price fell back to $22.95. The
Post reported that passing off a one-time gain as part of operating
earnings didnt fool or impress analysts and is something they
hoped not to see again.
Required:
a. Use efficient securities market theory to explain the rise in
Canadian Tires share price on May 2 2001 and the rapid
subsequent fall in share price.
The initial rise in Canadian Tires share price occurred for 2 reasons:
Reported earnings exceeded analysts expectations. Since
analysts earnings forecasts are a proxy for investor expectations,
investors would raise their probabilities of future firm performance.
The resulting buy decisions raised share price.
The rise in share price was reinforced by Mr. Sales comment that
the firm is pleased with its ability to deliver double-digit earnings
growth. This suggests reasonable persistence in Canadian Tires
increase in earnings. The subsequent fall in share price was due to
the markets realization that the persistence of Canadian Tires
earnings increase was less than at first believed. This was due to
the inclusion of an $8 million one-time gain in operating earnings
b. Was Canadian Tire correct in including the $8m one-time gain in
net income? Explain.
The sale of assets appears to be infrequent and not typical of Canadian
Tires normal operations, and the timing of the sale would be under
managements control. It should be reported under OCI.
c. Evaluate the persistence of Canadian Tires reported net income
of $0.37 per share (no calculation required). Does the fact that Mr.
Sales ignored this item in his press release affect your evaluation?
Explain why or why not.
Persistence is low. Inclusion of the one-time gain lowers persistence of
operating earnings. Also, if the one-time gain is excluded, Canadian Tires
earnings per share were lower than for the same quarter of the previous
year. If this continues, even the gain-excluded earnings will not persist.

5-20 On 13 September 2005, the shares of Best Buy Co fell from $5.14
to $45.22 on NYSE, a decline of 10.2%. The decline followed the release
of its second quarter 2005 financial results. Best Buy is a large North
American retailer of consumer electronics and appliances, with over
700 stores in the United States and Canada, including the Future Shop
chain. Best Buy reported earnings of $0.37 per share, compared with
$0.30 for the same quarter of 2004. However, its 2005 earnings
included an expense for stock based compensation. If the 2 nd quarter of
2004 had included this expense, earnings for that quarter would have
been $0.26 per share. Sales revenue rose 10% for the quarter, including
a 3.5% increase in same-store sales (indicator for retail company
performance). Its gross profit rose to 25.5% of sales from 24.2% a year
earlier. In its new release accompanying the financial results,
management predicted earnings of 28 to 32 cents per share for its 2005
3rd quarter. This prediction included the effects of Hurricane Katrina,
which, in late August 2005, caused widespread devastation in parts of
the southern US and led to a brief closing of 15 company stores.
Management announced plans to open 86 new stores in US and Canada
during fiscal year ending February 25 2006. While management
expressed concerns about the effects of high gasoline prices on
consumer spending, it reiterated its guidance that future annual growth
in earnings from continuing operations would be about 26%. Analysts
had estimated 2nd quarter 2005 earnings of 38 cents per share, and
third quarter earnings of 34 cents. The NYSE Composite Index closed at
7578.25 on September 13 2005 and 7762.60 on September 12 2005.
Best Buys stock beta, as per its website, is 1.84. The risk-free interest
rate at this time was approximately 0.0001 per day.
Required:
a. What percentage return on Best Buys stock price would you
expect on September 13 2005, strictly as a result of market wide
(i.e. systematic) factors? Use the market model and show your
calculations. Note the theoretical relationship j = Rf (1-j )
The return on the market portfolio (i.e., the NYSE Composite index),
ignoring dividends, on September 13 was (7762.60 7578.25)/7578.25 =
184.35/7578.25 = .0243

b. What was the abnormal return on Best Buy stock on 13


September 2005? Is this return consistent with securities market
efficiency? Explain why or why not.
The abnormal return on Best Buys stock on September 13, 2005 was
-.1020 - .0446 = - .1466.
This decline of almost 15% is considerably
worse than the expected increase of 4.46%. The market must have
interpreted the information in the companys earnings announcement as
bad news.
Explanations for the bad news interpretation:

The market was expecting earnings of 38 cents per share for the
second quarter. Actual earnings came in at 37 cents. Under market
efficiency, Best Buys stock price on September 12 would have
incorporated this expectation. Thus, the market was disappointed.
Stock price also included an expectation of 34 cents earnings per
share for the third quarter, whereas the companys current forecast
was for earnings in the range of 28 to 32 cents.
Investors were worried about the effects of hurricane Katrina on the
companys near-term profitability.
Investors were worried about the effects of high energy prices on
consumer spending.

However, the companys announcement also contained some good news


from management, consisting of sales and gross profit increases, new
store openings, and reiteration of expected 26% future earnings growth.
The fall in Best Buys stock price seems consistent with securities market
efficiency if we accept that the impact of the bad news outweighed that of
the good news.
c. Evaluate the persistence of the news (i.e. the increase from 26
cents/share to 37 cents/share) in Best Buys second quarter 2005
earnings.
The negative effects of hurricane Katrina would be of low persistence,
particularly since management states that the store closings were brief.
Managements concern about high gasoline prices also suggests low
persistence of the earnings increase, since if consumer spending falls, this
would reduce future profitability. However, other events suggest that the
earnings increase will persist. These include the increase in sales,
particularly same-store sales, the increase in the gross profit ratio, and the
opening of additional stores. Furthermore, management has reiterated its
guidance of 26% future growth in earnings from continuing operations. A
reasonable conclusion is that the earnings increase is of medium to high
persistence.

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