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Practice Examination For Financial Accounting Theory Semester One 2022 Department of Accounting

ACCT30001

FINANCIAL ACCOUNTING THEORY

QUESTION ONE ( 4 marks)

Investing in the Age of High-Frequency Trading, Falling Volumes and Widening Bid- Ask Spreads

By Frank Holmes

CEO and Chief Investment Officer

U.S. Global Investors

(https://www.valuewalk.com/2014/09/price-discovery-high-frequency-trading/)

As investment managers, one of our most important fiduciary responsibilities is buying and selling stocks for the best possible price and execution. We do this by using the statistical strategies   I’ve   previously   covered,   from   monitoring   short-   and   long-term   cycles; implementing probability models such as standard deviation, mean reversion and oscillators;

and identifying the relative valuation of stock with the portfolio manager’s cube. If only it were that simple.

In the past few years, price discovery—or the act of finding the right” price for a security— has become much more challenging because of falling stock volume and widening bid-ask spreads. These challenges are directly attributable to the infiltration of high-frequency traders into the market, not to mention the expansion of dark pools and non-exchange trading.

[article continues]

Required:

Why do bid-ask spreads widen with information asymmetry?

QUESTION TWO (2 + 5 = 7 marks)

Shown above is the Statement of Comprehensive Income for Harvey Norman Ltd for the year

ended 30 June 2018.

Required:

A) As a shareholder of Harvey Norman Ltd, which Comprehensive Income line (Other comprehensive income”; Total comprehensive income”; or the two items under Total comprehensive income attributable to”) item would be most relevant to you? Explain.

Explain the relevance to valuation of the items under Items that may be reclassified …” and Items that will not be reclassified …”. Specifically, you should discuss the likely magnitude of share price responses (earnings response coefficient) to unexpected comprehensive earnings associated with these items

QUESTION THREE (9 marks)

The ASX S&P 200 Healthcare Index contains the following firms.

You are tasked with performing a comparables analysisto value (using P/E ratios etc)

Ansell Ltd.

Company

Headquarters

Products

Market Value

Ansell Ltd

Australia

Gloves and Protective Equip.

$3.6 billion

Australian Pharama.

Industries Ltd

Australia

Medical Distribution

$0.7 billion

Cochlear Ltd

Australia

Medical Devices

$12. 1 billion

Estia Health Ltd

Australia

Aged Care Facilities

$0.7 billion

Fisher & Paykal            Healthcare Corporation Limited

Australia

Medical Devices

$9. 1 billion

Mayne Pharma Group Ltd

Australia

Drug Manufacturer

$0.7 billion

Nanosonics Ltd

Australia

Medical Devices

$1.9 billion

Ramsay Healthcare Ltd

Australia

Private Hospitals

$13.3 billion

ResMed Inc.

United States

Medical Devices

$28.6 billion

Sigma Healthcare Ltd

Australia

Pharmacies

$0.6 billion

Sonic Healthcare Ltd

Australia

Medical Services

$13.4 billion

Required:

Based on the information presented in the table above, what concerns would you have using the remainder of the ASX S&P200 Healthcare Index as a comparable peer group with which to value Ansell Ltd? Explain your concerns in detail.

QUESTION FOUR (4 + 6 = 10 marks)

Agency theory suggests that a way to motivate managers to act in the best interests of the  owners/shareholders is to link managerial compensation to performance measures, such as net income or share price.

Required

A) What happens if too much compensation risk is eliminated?

B) Inclusion of shares and options in managerial compensation packages has been attributed to the desire of the owners/shareholders to provide managers an incentive to undertake policies that benefit the firm's long-term rather than short-term interests.

If this is true, why not compensate the manager only on the basis of share return (for example, only by stock options or restricted stock)? In other words, under these circumstances, what are the justifications for having a cash or bonus element in the compensation package?

.

QUESTION FIVE (3 + 7 = 10 marks)

Title: Corporate Earnings are Flatlining - and Thats Terrible News for the Stock Market

Source: Reuters

By: Shawn Tully

(https://fortune.com/2019/08/31/stock-market-corporate-earnings-flat-bad-news/)

The explosion in corporate profits that lifted share prices to what are still near-record levels is ending.

That's the evidence from a recent report issued by FactSet, the research firm that compiles Wall Street analysts' estimates of future earnings-per-share for the S&P 500, and compares those predictions to what the 500 actually achieves

[article continues] …

All told, America's largest companies are paying out a sums equal to something like 95% of   their net profits in repurchases and dividends. But it's well known that they're borrowing a big chunk of the buyback cash on the pretext that their stocks is a great buy at current prices, a     questionable view since the S&P is selling at an expensive price-to-earnings multiple of 21.7. It's likely that the 500 are using borrowed money for around one-third of the repurchases, and funding the rest with 25% of net profits. They're also retaining around one-third of GAAP       earnings, and plowing that money back into expansion via new plants and R&D facilities.

[article continues] …

Required:

A) What motivations could firm managers have to repurchase stock at prices potentially above fair price?

B) How would these repurchases affect the income statement and balance sheet metrics used in executive compensation contracts?

QUESTION SIX ( 3 + 3 + 5 = 11 marks)

Title: Nintendo shares dive as company plays down Pokemon GO's earnings impact Source: Reuters

By: Junko Fijita

(https://www.reuters.com/article/us-nintendo-pokemon-stocks-idUSKCN10504G)

TOKYO (Reuters) - Shares in Nintendo Co tumbled as much as 18 percent on Monday after the company said Pokemon GO would have a limited impact on its earnings - their biggest setback so far after a huge run-up on the smash-hit game.

The Kyoto-based gaming company, which is due to report  first-quarter results this week, surprised markets with a statement on Friday that income garnered through its 32 percent stake in affiliate Pokemon Company, which owns the licensing rights, would be limited and that it did not plan to revise its earnings outlook for now.

Recording its biggest decline since October 1990, the stock ended down 17.7 percent, or by 5,000 yen - the daily limit allowed.

But some market players said Nintendo was being disingenuous, adding that there were few expectations of upward revisions to its profit targets so early after the game’s launch and that it was clear the game would be key to earnings.

“The market has overreacted to the Nintendo statement,” said David Gibson, a senior analyst at Macquarie Securities Group, noting the game in Japan had broken records with 10 million downloads in one day.

“I believe that Pokemon GO will be material in the company’s earnings given the current trends for the game.”

Pokemon  GO’s  success has  triggered  massive buying  in Nintendo  shares  and  even with Monday’s decline, the shares are still up some 60 percent compared with levels prior to the game’s July 6 launch in the United States, Australia and New Zealand, adding nearly $12 billion in market value.

Yasuo  Sakuma,  portfolio  manager  at  Bayview  Asset  Management,  said  he  still  saw  the company’s shares as cheap given the potential for Nintendo to reap rewards from other strong character franchises as it forays deeper into mobile gaming … .

[article continues ]

Nintendo, which reports earnings on Wednesday, has forecast a 37 percent rise in operating profit to 45 billion yen ($425 million) in the year to March. While it is expected to see upside from Pokemon GO it will also have to contend with a strong yen which eats into the value of earnings garnered abroad

[article continues ]

Required

A) Suggest and explain reasons as to why the stock price fell by 18%.

B) David Gibson suggests that the market overreacted to earnings announcement. Is this consistent with an efficient market? Why or why not?

C) Suggest and explain possible reasons as to why the market may overreact in this circumstance?

QUESTION SEVEN (5 marks)

Title: How Buffett Won His $1 Million Bet

Source: Forbes

By: John F. Wasik (https://www.forbes.com/sites/johnwasik/2018/01/08/how-buffett-won-his-1-million-bet/#1834cda32a6c)

When investing, sometimes the best way to make money in the stock market over time is to do nothing. Just invest passively.

That's what Warren Buffett did in making a $1 million bet that he could do better than a     portfolio of hedge funds. Did the Oracle of Omaha find some great, bargain-priced stocks? Did he make the deal of the century by finding an emerging tech company?

Nope. He simply said that by investing in a boring, low-cost stock index fund you could      outperform most hedge funds over the past decade. He made no new investments and didn't time the 2008 market crash. He just stayed put in an index fund.

[article continues]

Required:

Fully explain how an efficient market will assist Warren Buffer in winning this bet.

QUESTION EIGHT (4 marks)

Identify on what basis each of the following assets or liabilities should be measured:

(i)  Investment in a trading portfolio of shares listed on ASX stock exchange (1 mark) (ii) Bonds that are debt

QUESTION NINE (5 marks)

In August 2016 ABC Ltd reported a record earning of $15 per share. BHP Ltd reported         earnings per share of $12. The prior year’s earning per share of ABC Ltd and BHP Ltd was  $10 and $18 respectively. The analysts earning expectation of earning per share immediately prior to the earnings announcement for ABC Ltd and BHP Ltd was $15 and $9 respectively.

Required

Which company would have the greatest security price response to its earnings announcement in August 2016 and why?

QUESTION TEN (10 marks)

At the end of 2012, you forecast the following cash flows (in millions) for a firm with net debt of $759 million:

2013

2014

2015

Cash flow from operations Cash investment

$1,450

1,020

$1 ,576

1 124

$1,718

1,200

You forecast that free cash flow will grow at a rate of 4 percent per year after 2015. Use a required return of 10 percent in answering the following questions.

a. Calculate the firm's enterprise value at the end of 2012.

b. Calculate the value of the equity at the end of 2012.