a1: Buy bonds of Risky Mining Ltd. These pay 14.4% interest, unless Risky goes bankrupt, in which case Marie will lose her principal and interest.

a2: Buy savings bonds, paying 6.4% interest. Marie 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. Marie’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 $ 1,064, etc. Marie is a rational decision maker.

Required

a. Based on her prior probabilities, which action should Marie take? Show your calculations.

b. Before making a final decision, Marie 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, Marie observes that it is LO. On the basis of her prior experience in bond investments, Marie knows the following conditional probabilities:

Which action should Marie 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 partb.

Transcribed Image Text:

Debt-to-Equity Ratico Future State LO NB (Not Bankrupt 0.50 0.05 HI 0.50 0.95 B (Bankrupt