Question

The president of Southern Semiconductor Corporation (SSC) made this statement in the company’s annual report: “SSC’s primary goal is to increase the value of our common stockholders’ equity.” Later in the report, the following announcements were made:

a) The company contributed $1.5 million to the symphony orchestra in Birmingham, Alabama, its headquarters city.

b) The company is spending $500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand in China.

c) 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, SSC plans to shift its emergency funds from Treasury bonds to common stocks.

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

(250 words)

Answer 1

a) The company contributed $1.5 million to the symphony orchestra in Birmingham, Alabama, its headquarters city.

It's an act of philanthropy and hence it's a subjective issue. The debate over such issues had been there historically. Monetarily such an investment is not going to generate rewards commensurate with the quantum of investment. This investment itself will not generate any monetary value. Further, this investment has also reduced the quantum of capital, the firm could have deployed in some other NPV positive projects to generate returns and create value for the shareholders. On the other side, the company's contribution has gone towards a noble cause. It can induce publicity for the company. This investment may also be eligible as deduction for tax purposes. It can be seen as an investment in community building and give way to cultural attraction. However these are softer benefits and they are far outpaced by the monetary losses.

Hence, shareholders may not view this action favorably and share price may decrease due to this.

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b) The company is spending $500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand in China.

In the short run, the earnings will remain depressed. However in the medium to long run, this will bring geographical diversification and probably positive cash flows. The company would have performed capital budgeting analysis prior to implementing this project. Such investments made today are expected to generate cash flows in future. So, in the short term, this project may depress the earnings, but in the long run it will generate the value. Shareholders are interested in long term value creation rather than short term gains.

Hence shareholders should react positively to this. And the share price should increase on account of this.

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c) 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, SSC plans to shift its emergency funds from Treasury bonds to common stocks.

US Treasury bonds are considered to be safe investments where capital as well as small return on capital is assured. On the contrary, investments into common stocks are considered to be very risky where neither the return of capital nor the return on capital (dividend, capital gain etc) is assured. Further, investment into common stocks should have a longer investment horizon. If funds are required in short run, it may force the company to liquidate the investments at a time when capital markets are depressed thus not fetching the kind of return shareholders expect from the equity investments. '

Hence, shareholders will not view this as a positive development and share price may drop (reduce, decrease) on account of this.