During the 1990s, General Electric put together a long string of consecutive qua

Question

During the 1990s, General Electric put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings forecast of Wall Street stock analysts. Some skeptics wondered if GE "managed" earnings to meet Wall Street's expectations. Skeptics were concerned that GE had used accounting gimmicks to "smooth" earnings --to conceal the true volatility in its business. Questions: 1. How do you think GE's history of meeting or beating earnings forecasts affected its cost of capital? 2. If investors learn that GE's performance was achieved largely through accounting gimmicks, how do you think they would respond? 3. Let's assume you have $10,000 to invest in the stock market. Would you consider investing in the stock of a company that was rumored to have used accounting gimmicks to manage its earnings? Please explain.

Explanation / Answer

Ans1 . If we take a scenario of GE history's beating earnings , keeping in mind that they are acutally performing well , then the cost of capital would be less as lender are willing to lend at cheaper rate of interest because there's less risk involved of company being bankcrupt or default on repayment as earnings are growing therefore they have enough cashflows to pay off interest and principal amount.

For cost of equity, investor will expect less rate of return , since risk is les because of its consistent performance and beating the wall street expectation.

Ans2 . If investors learn that GE's performance was achieved largely through accountinh gimmicks , investor would take out their money from the company as they dont want to be part of company that is involved in unethical pratice , due to which Company's stock price will FALL big time. Also , from perspective of lenders (banks and other institution who invest through debt instrument ) would like to exit by asking for their money by seeling their assets or through cash in order to exit as they foresee a case of default in future.

ANS3. No, one would never like to invest in the company which follows unethical pratice, one of the key factor investor consider while investing is the company's management and their course of action towards the company or vision of the company. One should never invest in such companies as they may disappear anytime and investor will loose money as well as courage to invest anywhere else.

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