Chapter-1-solutions-5th-edition-112612-final

©2013CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.Chapter1AFrameworkforBusinessAnalysisandValuationUsingFinancialStatementsDiscussionQuestions1.John,whohasjustcompletedhisfirstfinancecourse,isunsurewhetherheshouldtakeacourseinbusinessanalysisandvaluationusingfinancialstatements,sincehebelievesthatfinancialanalysisaddslittlevalue,giventheefficiencyofcapitalmarkets.ExplaintoJohnwhenfinancialanalysiscanaddvalue,evenifcapitalmarketsaregenerallyseenasbeingefficient.Theefficientmarkethypothesisstatesthatsecuritypricesreflectallavailableinformation,asifsuchinformationcouldbecostlesslydigestedandtranslatedimmediatelyintodemandsforbuysorsells.Theefficientmarkethypothesisimpliesthatthereisnofurtherneedforanalysisinvolvingasearchformispricedsecurities.However,ifallinvestorsadoptedthisattitude,noequityanalysiswouldbeconducted,mispricingwouldgouncorrected,andmarketswouldnolongerbeefficient.Thisiswhytheremustbejustenoughmispricingtoprovideincentivesfortheinvestmentofresourcesinsecurityanalysis.Eveninanextremelyefficientmarket,whereinformationisfullyimpoundedinpriceswithinminutesofitsrevelation(i.e.,wheremispricingexistsonlyforminutes),Johncangetrewardswithstrongfinancialanalysisskills:1.Johncaninterpretthenewlyannouncedfinancialdatafasterthanothersandtradeonitwithinminutes;and2.FinancialanalysishelpsJohntounderstandthefirmbetter,placinghiminabetterpositiontointerpretothernewsmoreaccuratelyasitarrives.Marketsmaybenotefficientundercertaincircumstances.Mispricingofsecuritiesmayexistdaysorevenmonthsafterthepublicrevelationofafinancialstatementwhenthefollowingthreeconditionsaresatisfied:1.relativetoinvestors,managershavesuperiorinformationontheirfirms’businessstrategiesandoperation;2.managers’incentivesarenotperfectlyalignedwithallshareholders’interests;and3.accountingrulesandauditingareimperfect.Whentheseconditionsaremetinreality,Johncouldgetprofitbyusingtradingstrategiesdesignedtoexploitanysystematicwaysinwhichthepubliclyavailabledataareignoredordiscountedintheprice-settingprocess.Capitalinmarketefficiencyisnotrelevantinsomeareas.Johncangetbenefitsbyusingfinancialanalysisskillsinthoseareas.Forexample,hecanassesshowmuchvaluecanbecreatedthrough2Instructor’sManual©2013CengageLearning.AllRightsReserved.Maynotbescanned,copiedorduplicated,orpostedtoapubliclyaccessiblewebsite,inwholeorinpart.acquisitionoftargetcompany,estimatethestockpriceofacompanyconsideringinitialpublicoffering,andpredictthelikelihoodofafirm’sfuturefinancialdistress.2.In2009,LarrySummers,formerSecretaryoftheTreasury,observedthat“inthepast20-yearperiod,wehaveseenthe1987stockmarketcrash.WehaveseentheSavings&Loandebacleandcommercialrealestatecollapseofthelate80’sandearly90’s.WehaveseentheMexicanfinancialcrisis,theAsianfinancialcrisis,theLongTermCapitalManagementliquiditycrisis,theburstingoftheNASDAQbubbleandtheassociatedEnronthreattocorporategovernance.Andnowwe’veseenthis[globaleconomiccrisis],whichismoreseriousthananyofthat.Twentyyears,7majorcrises.Onemajorcrisisevery3years.”Howcouldthishappengiventhelargenumberoffinancialandinformationintermediariesworkinginfinancialmarketsthroughouttheworld?Cancrisesbeavertedbymoreeffectivefinancialanalysis?Financialintermediariesperformavarietyoffunctionsthataredesignedtomitigateproblemsinourfinancialmarkets.Auditorscertifythecredibilityoffinancialreports;auditcommitteeshiretheexternalauditorsandoverseeboththeinternalandexternalauditorstoensurethattheydoathoroughjobofassuringthecompany’sfinancialinformationisreliableandnotfraudulent.Corporateboardsaretaskedwithmonitoringandappointingthefirm’sCEOandwithoverseeingitsstrategy.Financialanalystsevaluateafirm’sfinancialperformanceandvaluationandassesswhetherastockisaworthwhileinvestment,andalsoensurethatthereiscommoninformationonastockinthemarkettoreduceadverseselectionproblems.Investmentbankshelptoprovidegoodcompanieswithaccesstocapitalandtohelpinsurethatinvestorscanallocatecapitaltogoodbusinesses.Andsothelistgoeson,includinginvestmentmanagers,hedgefundmanagers,andthebusinesspress.ItisaninterestingquestionastowhythesevariousinstitutionsfailedtodetecttheproblemsunderlyingthecrisisidentifiedbyLarrySummers.Oneexplanationisthattheyfacetheirownconflictsofinterest.Auditorshavecertainlyreceivedcriticismforauditfailures.Somesuggestthatthisarisesbecauseauditorsare(perhapsunconsciously)reluctanttotakeahardlineagainstimportantclientsforfearoflosingtheaccount.Similarconcernshavebeenraisedaboutfinancialanalysts,whicheitherworryaboutthereactionsofcorporatemanagers,majorclients,orinvestmentbankersattheirfirmiftheywritenegativereportsaboutcompaniestheyfollow.Corporateboardshavebeencriticizedforbeingbeholdentotheseniorexecutivesofthecompaniestheyoversee.Recentgovernancechangeswereintendedtocorrectsomeoftheseconflictsofinterest.Forexample,intheU.S.theSarbanesOxleyActwasintendedtogiveAuditCommitteesmorecloutandchangetheincentivesofauditors.TheGlobalFinancialSettlementandRegulationFairDisclosurewereintendedtoreducetheconflict