Sonja, a rational investor, has $2,500 to invest for one year while she completes her professional accounting designation. She is contemplating investing the full amount in shares of Northeastern Oil & Gas Ltd. (a₁) or in a risk-free government bond yielding an annual return of 1.96% (a₂).

Sonja identifies two states of nature:

State H: Northeastern has high future cash flow.

State l: Northeastern has low future cash flow.

On the basis of her prior information about Northeastern, Sonja assesses the following subjective prior state probabilities:

State H: 0.4

State L: 0.6

The following is the payoff table for these two investments. Payoffs from Northeastern shares include dividends and estimated capital gain for the year. Capital gain is based on the average analyst forecast for Northeastern's share price. Payoffs are net of (i.e., they exclude) the original investment.

Sonja is risk-averse, with utility equal to the square root of the net dollar payoff.

Required

a. On the basis of her prior probabilities, which act should Sonja take? Show calculations.

b. Instead of acting now, Sonja decides to obtain more information about Northeastern by reading its annual report. She knows that financial statements are based on a mixed measurement model. Also, she is a student of financial accounting theory, and estimates the quality of financial statements prepared according to these standards by the following information system:

Good evidence means that a company reports profits that are higher than the average analyst forecast. Bad evidence means that the company's profits are less than forecast. Upon reading the current annual report, Sonja finds it is good. Which act should Sonja take now? Show calculations.

c. After buying the Northeastern shares, Sonja is disappointed to note that the market price of its shares begins to fall, despite the good news in its earnings report and a rising stock market index. She now suspects that the good news in Northeastern's financial statements was not as good as she originally believed. Is this possible? Give reasons why or why not.

Transcribed Image Text:

State H L $576 $36 Act az $ 49 $49