You are given the diagram below. Explain what the diagram shows in relation to the module 1 topic on accounting information and capital markets.
The diagram above is based on research findings done by Beaver, Clarke and Wright (1979) and Foster, Olsen and Shevlin (1984).
It shows the magnitude of forecast error and the magnitude of share price reaction in the share market. The researchers on the basis of their findings found out that the results were consistent with the Ball and Brown (1968) study. They found that there is a relationship between forecast error in Earnings Per Share and the share price reaction. The researchers instead of grouping the firms into two groups grouped them into ten portfolios. They determined these portfolios on the basis of forecast earnings per share.
The diagram ranks all the firms based on the magnitude of forecast Earning Per Share. Portfolio 1 firms are the worst performing firms as they have the most negative earnings per share at 10% and therefore have the most negative share price reaction whereas on the other hand, Portfolio 10 firms are the best performing firms in relation to having positive forecast earnings per share at 10% and therefore have the highest positive share price reaction. In other words, for Portfolio1 and 10 firms the news of forecast error comes as a big surprise to the investors and therefore there is a greater share price reaction for these firms. The firms under Portfolio 2 are the next worst performing set of firms whereas the firms under Portfolio 9 are the next best performing firms. Similarly, as we further move down from one portfolio to another there are the next worst or the next best performing firms and the share pric...
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...m can be reduced if debtholders price protect themselves. In that case the cost of the opportunistic behaviour will be borne entirely by the firm only and there will be an incentive for the firm to align their interest with that of the debtholders by getting into a debt contract that specifically mentions restrictive covenants which includes:
• Imposing limitations on the amount of dividends that a company may pay to its shareholders.
• The debtholders can charge higher rate of interest from the firm.
• The firm will not issue any more of long-term debts.
• The firm will not pledge its assets to any other firm.
This will help to reduce conflicts of interest between the debtholders and the management because the debtholders only want to protect their funds and ensure that their interest is paid on time whereas the firm managers only want to maximise value of the firm.
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