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Chapter 25: Problem 16

Explain the effect on a company's stock price today of each of the following events, other things held constant. a. The interest rate on bonds falls. b. Several companies in the same sector announce surprisingly higher sales. c. A change in the tax law passed last year reduces this year's profit. d. The company unexpectedly announces that due to an accounting error, it must amend last year's accounting statement and reduce last year's reported profit by \(\$ 5\) million. It also announces that this change has no implications for future profits.

Short Answer

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a. The interest rate on bonds falls. Answer: The company's stock price increases due to higher demand for stocks as investors move away from bonds. b. Several companies in the same sector announce surprisingly higher sales. Answer: The company's stock price rises as investor confidence in the industry grows, leading to more investments in the sector. c. A change in the tax law passed last year reduces this year's profit. Answer: The company's stock price declines as lower profits make the company less attractive to investors. d. The company unexpectedly announces an accounting error and decreases last year's reported profit by $5 million. Answer: The company's stock price may temporarily decrease due to uncertainty among investors, but could potentially recover in the long run as the error does not affect future profits.

Step by step solution

01

a. The interest rate on bonds falls.

A decrease in the interest rate on bonds reduces the return on investment that investors can expect from bonds. Consequently, investors gravitate towards the stock market, increasing the demand for stocks. A higher demand for stocks leads to a rise in stock prices, resulting in the company's stock prices increasing today.
02

b. Several companies in the same sector announce surprisingly higher sales.

Positive news from the industry tends to boost investor confidence in the entire industry's performance. If several companies in the same sector as the company in question report higher sales, this could have a positive effect on the overall outlook of the sector. As a result, investors are likely to invest more in that sector, thus raising the stock price of the company in question.
03

c. A change in the tax law passed last year reduces this year's profit.

A change in tax law resulting in reduced profits for the company will make the company less attractive to investors. Since investors aim to maximize their returns, a company with lower profits will likely experience decreased demand for its stock. This leads to a decline in the stock price today.
04

d. The company unexpectedly announces an accounting error and decreases last year's reported profit by $5 million.

In this situation, the company has acknowledged an accounting error and explained that it has no impact on future profits. This disclosure may create some uncertainty among investors and may cause them to doubt the company's financial reporting. This uncertainty could temporarily drive down the company's stock price. However, since the announcement clarifies that the error does not affect future profits, it is possible that the stock price will recover in the long run, as investors reassess the situation.

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Most popular questions from this chapter

For each of the following, is it an example of investment spending, investing in financial assets, or investing in physical assets? a. Rupert Moneybucks buys 100 shares of existing Coca-Cola stock. b. Rhonda Moviestar spends \(\$ 10\) million to buy a mansion built in the $1970 \mathrm{~s}$. c. Ronald Basketballstar spends \(\$ 10\) million to build a new mansion with a view of the Pacific Ocean. d. Rawlings builds a new plant to make catcher's mitts. e. Russia buys \(\$ 100\) million in U.S. government bonds.

What are the important types of financial intermediaries in the U.S. economy? What are the primary assets of these intermediaries, and how do they facilitate investment spending and saving?

Explain how a well-functioning financial system increases savings and investment spending, holding the budget balance and any capital flows fixed.

In \(2014,\) Congress estimated that the cost of increasing support and expanding pre-kindergarten education and infant and toddler childcare would cost \(\$ 28\) billion. Since the U.S. government was running a budget deficit at the time, assume that the new pre-K funding was financed by government borrowing, which increases the demand for loanable funds without affecting supply. This question considers the likely effect of this government expenditure on the interest rate. a. Draw typical demand \(\left(D_{1}\right)\) and supply \(\left(S_{1}\right)\) curves for loanable funds without the cost of the expanded pre-K programs accounted for. Label the vertical axis "Interest rate" and the horizontal axis "Quantity of loanable funds." Label the equilibrium point \(\left(E_{1}\right)\) and the equilibrium interest rate \(\left(r_{1}\right)\). b. Now draw a new diagram with the cost of the expanded pre-K programs included in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point \(\left(E_{2}\right)\) and the new equilibrium interest rate \(\left(r_{2}\right)\) c. How does the equilibrium interest rate change in response to government expenditure on the expanded pre-K programs? Explain.

How would you respond to a friend who claims that the government should eliminate all purchases that are financed by borrowing because such borrowing crowds out private investment spending?
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