Question

During the 1990s, GTR Corporation put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings forecasts of Wall Street stock analysts. Some skeptics wondered if GTR managed earnings to meet Wall Streets expectations, meaning that GTR used accounting gimmicks to conceal the true volatility in its business. How do you think GTRs long run of meeting or beating earnings forecasts affected its cost of capital? If investors learn that GTRs performance was achieved largely through accounting gimmicks, how do you think they would respond?

Answer 1

Financial statements are prepared by any company to meet the information needs (indicating the profitability) of the investors and capital providers. A highly risky company would attract lessor investors who in turn will require higher rates of return on their investments resulting in higher cost of capital for the company. on the other hand, a company enjoying good profits and credibility will be attract investments at a lower cost of capital because of lesser risk.

In the given case,  GTR Corporation managed to meet or beat the earnings forecasts which indicated a sound financial position for the company during the relevant quarters. As a result, investors must have viewed the company as less risky and must have provided the capital at lower cost. In other words, these forecasts would have resulted in lower cost of capital for the company.

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

If investors learn that GTR Corporation's performance was achieved largely through accounting gimmicks, investor would take out their money from the company as they don't want to be part of company that is involved in unethical practice, 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 selling their assets or through cash in order to exit as they foresee a case of default in future.

violation of reporting practices or use of unfair methods to present a better financial position is unethical. In such a case, most of the existing investors would have withdrawn their investments. Moreover, it would have been difficult for GTR Corporation to raise more money from the market resulting in an increase in the cost of capital for the company.