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19. a. Persistence of net income before the foreign exchange gain seems reasonably
high, since the dramatic increase in these earnings, from a loss of $32 million in Q3, 2003
to a gain of $82 million in Q3, 2004, is likely due to the “red-hot” materials and energy
sector. Assuming that prices in this sector were unlikely to fall in the foreseeable future,
current core earnings will continue.
Persistence of the foreign exchange gain is less clear. If the Canadian dollar should
continues to appreciate relative to the U.S. dollar, the gain will persist, and vice versa.
Overall, the persistence of net income seems mixed. Since the foreign exchange gain of
b. Probably, low R&D costs would have little effect on the company’s ERC since
c. Note: Superior answers will back up their explanation with calculations as
follows:
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The opening price of Abitibi shares on Oct. 21 was:
The actual return on Abitibi stock on October 21 was thus:
The expected return on Abitibi stock, from the market model, and using
the theoretical relationship αj = Rf (1 – βj), was
Abnormal return was thus:
Consequently, the CEO’s claim that the market underreacted is questionable. Relevant
considerations include:
• The analyst’s forecast for Q3/04 was a loss of $27 million, but earnings, both
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20. a. The return on the market portfolio (i.e., the NYSE Composite Index), ignoring
dividends, on September 13 was
According to the market model, the expected return on Best Buy’s stock on that
day was:
b. The abnormal return on Best Buy’s stock on September 13, 2005 was
Explanations for the bad news interpretation:
• The market was expecting earnings of 38 cents per share for the second
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All of these reasons would cause rational investors to revise downwards their
expectations of future profitability.
However, the company’s announcement also contained some good news from
Note: A good answer will consider at least some items each of bad and good
news. Given this, an argument that the good news outweighed the bad, so that
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c. The negative effects of hurricane Katrina would be of low persistence,
However, other events suggest that the earnings increase will persist. These
include the increase in sales, particularly same–store sales, the increase in the
21. a. IBM’s share price dropped because the market had originally been misled
about the persistence of IBM’s earnings. By failing to disclose the nature of the
gain, IBM conveyed the impression that it was persistent. Thus, the market
reaction to IBM’s current earnings was too high in retrospect. Once the market
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22. a. Calculate the expected return on Apple shares for the week ended April 30, 2013:
From the market model, we have Rjt = αj + βRMt
Where period t is the week ended April 30, 2013 and
where M is the NASDAQ Composite Index.
It seems that the equity market reacted favourably to Apple’s bond issue.
b. Reasons why it may be unwise to buy bonds used to finance a share buyback:
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• The share buyback may indicate that the company does not have a productive use for
the strain on the firm’s cash flow to meet interest payments.
• While interest rates on the new debt issues are low, they are likely considerably greater
than interest rates on risk-free debt due to the low interest rate environment. Since
A reasonable conclusion is that while the reasons it is unwise to invest in bonds used to finance a
share buyback are persuasive in general, the fact that the bond issue was successful suggests that
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Additional Problems
5A–1. In 1998, Stelco Inc. announced plans to alter its capital structure by redeeming
$99 million par value of its preferred shares at par. The dividend rate on these
shares was about 7.75% of par value. Consequently, after the redemption, the
portion of net income going to Stelco’s common shareholders will be
substantially increased.
Explain the impact of this redemption on the ERC of Stelco’s reported net
income.
5A–2. In 1991, the AICPA established a Special Committee on Financial Reporting.
This committee, made up of several leaders in public accounting, industry, and
academe, was charged with reviewing the current financial reporting model and
making recommendations on what information management should make
available to investors and creditors.
In 1994, the Committee made several recommendations in a report entitled
“Report of AICPA Special Committee on Financial Reporting” that it argued
should help investors and other users to improve their assessment of a firm’s
prospects, thereby increasing the decision usefulness of annual reports. Here is
one of its recommendations:
The Committee recommended that companies differentiate between core
activities and non–core activities in their income statement, balance sheet, and
cash flow statement. “A company’s core activities—usual and recurring events—
provide the best historical data from which users discern trends and relationships
and make their predictions about the future.” Non–core activities are defined as
“unusual and nonrecurring activities or events (non–core effects) as well as
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interest charges. Without adjustment, non–core effects can distort or mask an
important trend or relationship in the company’s ongoing business.”
Source: Excerpt reprinted with permission from report of the AICPA Special
Committee on Financial Reporting. © 1994 by American Institute of Certified
Public Accountants, Inc.
Required
a. Use the concept of earnings persistence to explain why the Committee
recommends separate reporting of the results of core activities on the income
statement.
b. Why does IAS 1 prohibit the use of the term “extraordinary items” in the
income statement?
Suggested Solutions to Additional Problems
5A–1. This reduction should increase Stelco’s ERC:
• From the standpoint of the common shareholders, preferred shares are
like debt since both debt and preferred shares rank prior to the common
shares in terms of interest and dividends and return of capital.
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increased default risk that accompanies the BN. The ERC should rise for
BN as well.
5A–2. a. Non–core activities are defined as unusual and nonrecurring. Thus, they
have low persistence, by definition. If these items are not identified as such then