You are an expert on GAAP and the quality of financial reporting, with extensive experience in rational investing. You determine the current quality of financial reporting as summarized in the following information system:

The states of nature refer to future firm performance. GN (good news) and BN (bad news) summarize the information content of current financial statements.
You are also a shareholder of HILO Ltd., which has just released its quarterly financial report, and are evaluating this report to decide whether to sell your shares now or hold them for another quarter.
Your prior probability of the high state is 0.7. The current market value (i. e., your payoff if you sell now) of your HILO Ltd. shares is $ 81. If HILO is in the high state, your payoff will be $ 100 if you sell at the end of the next quarter. If HILO is in the low state, your payoff will be $ 36 at the end of next quarter. You are risk averse, with utility equal to the square root of your payoff.

Required
a. HILO Ltd. has just reported its earnings, with net income before special items up 10% from the same quarter last year, and exactly equal to analysts’ consensus forecast ( assume that analyst forecasts are before special items). However, you notice a large, special item loss in net income that reduces net income to below the consensus forecast. Does the current financial report show GN or BN? Explain (no calculations required).
b. Based on rational decision theory, should you sell or hold your HILO shares? Show calculations.
c. Assume that HILO has reported steadily increasing quarterly earnings for several years, but that current earnings per share before special items are 2 cents below analysts’ consensus forecast, otherwise it’s the same scenario as in a. Would your evaluation of the GN or BN in earnings change? Explain why or why not (no calculationsrequired).

Transcribed Image Text:

GN BN High 0.9 0.1 State of Nature Low 0.2 0.8