Cisco Systems Inc. is a large provider of networking equipment, based in Silicon Valley, California. In August 2004, it released financial results for the quarter ended July 30, 2004. Its revenues increased by 26% over the same quarter of 2003. Its net income for the quarter was $1.4 billion or 21 cents per share, a 41% increase over the same quarter in 2003 and 5% in excess of the average analysts’ forecast of 20cents. However, Cisco’s share price fell almost 18% to $18.29 following the announcement. This fall in share price seems contrary to the results of Ball &Brown [1968] and subsequent researchers, who have documented a positive market response to good earnings news. Analysis of other financial statement information revealed the following. Inventory turnover declined to 6.4 from 6.8 in 2003, gross margin declined slightly, order backlog was down and, while revenue was growing, its rate of growth appeared to declining. Also, several analysts commented on an increase in inventories, suggesting lower accrual quality to the extent these inventories would be slow in selling. Furthermore, Cisco’s CEO, commenting on the quarter’s results, mentioned that the firm’s customers were becoming more cautious about spending. Required: (a) What is meant by securities market efficiency? Discuss the different types of efficient markets. (b) Is the market reaction in the case of Cisco consistent with efficiency? Explain why or why not.

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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Cisco Systems Inc. is a large provider of networking equipment, based in Silicon Valley, California. In August 2004, it released financial results for the quarter ended July 30, 2004. Its revenues increased by 26% over the same quarter of 2003. Its net income for the quarter was $1.4 billion or 21 cents per share, a 41% increase over
the same quarter in 2003 and 5% in excess of the average analysts’ forecast of 20cents. However, Cisco’s share price fell almost 18% to $18.29 following the announcement. This fall in share price seems contrary to the results of Ball &Brown [1968] and subsequent researchers, who have documented a positive market response to good earnings news. Analysis of other financial statement information revealed the following. Inventory turnover declined to 6.4 from 6.8 in 2003, gross margin declined slightly, order backlog was down and, while revenue was growing, its rate of growth appeared to declining. Also, several analysts commented on an increase in inventories, suggesting lower accrual quality to the extent these inventories would be
slow in selling. Furthermore, Cisco’s CEO, commenting on the quarter’s results, mentioned that the firm’s customers were becoming more cautious about spending.

Required:

(a) What is meant by securities market efficiency? Discuss the different types of efficient markets.

(b) Is the market reaction in the case of Cisco consistent with efficiency?

Explain why or why not.

Definition Definition Degree to which financial markets incorporate all available information into the prices of assets. In a more efficient market, the prices reflect the available information more than that in a weak efficient market. It is difficult for investors to outperform the market in a strong efficient market. This is because all the available information is already discounted in the asset's price. However, in a weak-form efficiency, the market does not reflect all information in the asset's price. As a result, it becomes easier to generate better returns in a weak form or an inefficient market.

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