Question

od OT P9-21 ETHICS PROBLEM During the 1990s, General Electric put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings fore- casts of Wall Street stock analysts. Some skeptics wondered if GE "managed" earn- ings to meet Wall Street's expectations, meaning that GE used accounting gimmicks to conceal the true volatility in its business. How do you think GE's long run of meeting or beating earnings forecasts affected its cost of capital? If investors learn that GE's performance was achieved largely through accounting gimmicks, how do you think they would respond?

Answer 1

A long run of meeting and beating the Wall street expectations will clearly put the stock in the limelight and Investors , both equity as well as debt would be highly demanding the stock, thereby increasing the price of equity shares as well as debt instruments and decreasing the cost of capital.

If Investors come to learn that GE's performance was actually achieved through accounting gimmicks, the reputation of GE will be lost, there might be a demand of an enquiry or an actual enquiry about their accounting gimmicks, investors would respond to the bad news by selling the shares,decreasing its price and increasing the cost of capital implying the high risk the stock now bears.