Question

The president of ABC made this statement in the company’s annual report: “ABC’s primary goal is to increase the value of our common stockholders’ equity. Later in the report, the following announcements were made:

1. The company contributed $1 million to the symphony orchestra in Chicago, IL, its headquarters city.
2. The company is spending $800 million to open a new plant and expand operations in South Vietnam. No profits will be produced by the Vietnamese operation for four years, so earnings will be depressed during this period versus what they would have been had the decision not been made to expand in South Vietnam.
3. The company holds about half of its assets in the form of U.S. Treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, ABC plans to shift its emergency funds from Treasury bonds to common stocks.

Discuss how ABC’s stockholders might view each of these actions and how the actions might affect the stock price.

Answer 1

1)

It is true that carrying out socially responsible program may entail huge cost but it does not contradict goal of maximization of wealth of shareholder. Such projects creates goodwill for the company.Having good reputation among local community is very important for sustaining business. Such projects entails concept of give and take whatever company is getting from public i.e profit, company is returning them part of profit in form of such project.

For example: If australian company 'Energex stopped spending some of it's money on alternative energy initiatives, that can be seen environmentally friendly, some of it's customer could decide to do business with other company which are more socially responsible.

Thus through such project company creates goodwill which will ensure continuity of the business in long term, thereby following principle of wealth creation for share holders

Thus with regards to $1 million to the symphony orchestra in Chicago, IL the shareholder will see as positive thing.

2)

Company has planned cap-ex( capital expenditure) and hence depreciation relating to it will be debited to profit and loss account, thus reducing profit. here shareholder will look that the company is going to receive economic benefits after the plant is commissioned and will lead to increase in profit. Further depreciation is non cash item hence will not affect the cash flow of existing business. Further share holders will consider source of funds since company has decided to do capital expenditure. whether project will be done using borrowed fund or internal accruals whatever the case company is unlikely to declare dividend since it will use funds in cap -ex.

Thus considering future earning of the company the shareholder will buy shares and hence prices will increase

3)

Treasury bonds are safe than equity stocks. if market crashes equity stocks might provide negative return.This creates uncertainity in mind of investor and hence share holders will sell shares and thus price of share will decrease