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The Valuation Approach to Decision Usefulness

a) Yale economist M. Keith Chen did experiments with monkeys in which they always finished up with one piece of apple. Sometimes the monkeys started off with two pieces of apple, one of which was taken away. At other times they started off with none, and were given one piece. The monkeys strongly preferred the second scenario, and disliked the first, where one piece of apple was taken from them.

i) Which behavioral theory was Chen testing? (1 mark)

ii) Under this bias, give two reasons why security prices would differ from theoretical prices predicted by the efficient security markets theory. (3 Marks)

b) (Kunda, 1990: 486) argues that in the audit setting, the more auditors aspire to benefit from their support for their client’s preferences, the more likely it is that they will find sufficient evidence and interpret it in a way that is aligned with the client’s preferences. Which behavioral bias does this describe? (1 mark)

c) Li (2010) finds that managers tend to use more first-person pronouns (relative to second- and third-person pronouns) in the Management Discussions and Analysis Section of the 10-K filings when firm performance is better. Which behavioral bias does this describe? (1 mark)

d) On January 26, 1995, The Wall Street Journal reported that Compaq Computer Corp. posted record 1994 fourth-quarter results. Despite $20.5 million in losses from the Mexican currency devaluation, and losses on currency hedging, earnings grew to $0.90 per share from $0.58 in the same quarter of 1993, on a revenue growth of 48%. However, cash flows from operations were negative for the year. Also, there were concerns about Compaq’s scheduled introduction of new products in March 1995, following a warning by Compaq’s CEO Eckhard Feiffer that first-quarter, 1995 earnings were likely to be “flat.”.

Use the Sloan (1996) accruals anomaly to predict the market returns on the day the earnings were released. ( 3 marks)

e) Assuming that investors are rational, define and explain two barriers to arbitrage that might explain why efficient securities market anomalies continue to exist. (4 marks)


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