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 December, 1993, 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%. Furthermore, Compaq captured the No. 1 market share spot, with shipments up 50% from 1993 and with slightly higher profit margin.
Nevertheless, on the same day, Compaq's shares fell by $5.00, a decline of about 12%. The Journal reported that analysts had been expecting earnings of about $0.95 per share. Also, there were concerns about Compaq's scheduled introduction of new products in March 1995 , following a warning by Compaq's CEO Exkard Feiffer that first-quarter, 1995 earnings were likely to be "flat"
Required
a. Use single-person decision theory and efficient securities market theory to explain why the market price fell.
b. Assume that the $20.5 million in losses from peso devaluation and currency hedging are a provision (i.e., an accrual), not a realized cash loss, at the end of the fourth quarter. Use the anomalous securities market results of Sloan (1996) to explain why the market price fell.
c. The Journal quoted an analyst as stating ‘the market overreacted." Use prospect theory to explain why the market might overreact to less-than-expected earnings news.
d. Which of the above three explanations for the fall in Compaq's share price do you find most reasonable? Explain.