Assignment
This case draws on the analysis in Appendix 8-A. An investor is considering two $100,000 investments: (1) ABC Company bonds maturing in one year and paying 12 percent interest at maturity and (2) U.S. Treasury Notes also maturing in one year and paying seven percent in tersest at maturity. The investor believes there is a .1 ° probability that ABC Company will default. If default were to occur, it is estimated that the investor would receive 80 cents on the dollar.
Required:
a. Determine the expected utility of each investment.
b. What is the value of perfect information?
c. Assume the investor can privately contract to obtain ABC Company's profit forecast for the next year. If default were not to occur, there is an estimated probability of .8 that the profit forecast would be positive, and a .2 probability it would be negative. If default were to occur, the probability of a positive forecast is .4, while the probability is .6 that the profit forecast would be negative. Calculate the utility of each investment based on the new information.
d. What does the maximum price an investor would be willing to pay for the new information?
e. Why might this type of private contracting not occur?
f. Why is this type of analysis dim cult to apply to real-world situations for studying economic consequences of alternative accounting policies?