Ajay is a rational, risk-averse investor with $5,000 to invest for one year. He has decided to invest this amount in a high-technology fem and has narrowed his choice down to either AB Lid or XY Ltd. AB is a highly speculative firm with good prospects but no estab lished products XY is a well-established firm with stable performance. The payoffs (net of amount invested) for each firm depend on its next years performance, as follows

For each firm, Ajay asses prior probabilities of 0.5 for the high- and low-performance states. His utility for his investment return is equal to the square root of the amount of net payoff received Required

a. On the basis of his poor probabilities, should Ajay invest in AB Ltd.

(a) or XY Ltd. (a)? Show calculations.

b. XY Ltd. has just released its annual report. Ajay decides to analyze it before investing. His analysis shows "good news" (GN). He consults Al, an expert in financial reporting standards, who is quite critical of the quality of current GAAP Al advises that, based on current GAAP, the information system for firms' annual reports is as follows:

The annual report of AB Ltd. is not due for some time, and nothing else has happened to cause Ajay to change his prior probabilities of ABs next year performance. Which investment should Ajay make now? Show calculations.

c. Concerned by several recent financial reporting failures, the regulatory authorities decide to act. They quickly introduce several new accounting standards, including tighter controls over revenue recognition and greater conservatism in asset valuation. New corporate governance regulations and restrictions on the ability of auditors to engage in non-audit services for their clients are also implemented. Al advises Ajay that the information system for annual reports following these new standards and regulations is as follows

Al advises Ajay to ignore the information system in part b and instead use this one to revise his prior probabilities of XY Ltd.'s next year's performance based on the GN in its annual report. AB Ltd. still has not reported and Ajay's prior probabilities of its performance are unchanged. Which act should Ajay now take? Show calculations,

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Next Year's Performance Return AB Ltd. XY Ltd. High $1,089 $324 Low $0 $196