Chapter 30: Problem 14

Explain why stock prices fall when a company is found to be carrying out unethical and illegal activities.

Short Answer

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A: Stock prices fall due to the combined effects of the damaged reputation, loss of investor confidence, legal consequences, decreased demand for the company's products/services, and decline in future profitability. The negative impact of these activities on the company's performance and public image leads to investors selling their shares, thus increasing the supply in the market and decreasing the stock prices.

Step by step solution

Understand the process of stock trading and its relation to stock prices

Stock prices are determined by the forces of supply and demand in the market, with investors constantly buying and selling shares. These transactions are based on the expectation of company performance, news and events, among other factors, which bring changes to the perceived value of the company and, consequently, its stock price.

Explain the role of reputation in a company's stock price

A company's reputation plays a crucial role in attracting and retaining investors, customers, employees, and partners. A good reputation often translates to higher stock prices, as it leads to increased trust, loyalty, and confidence in the company's long-term growth potential.

Illustrate the effect of unethical and illegal activities on reputation

Unethical and illegal activities, such as fraud, environmental crimes, or workplace harassment, harm the company's reputation, as it reflects poorly on the management, internal controls, and corporate culture. This can consequently lead to negative publicity and tarnish the company's public image.

Discuss the impact on investor confidence and stock prices

Due to the negative publicity and damage to reputation caused by the unethical and illegal activities, investors may lose confidence in the company's management and its future prospects. As a result, they might sell their shares and move to invest in other companies, thus increasing the supply of shares in the market, which would lead to a decrease in stock prices.

Explain the legal consequences and their effect on stock prices

Companies found to be participating in unethical and illegal activities often face legal consequences such as fines, penalties, or even forced closure. These legal consequences can directly impact the company's profitability and financial stability, as well as deter potential investors and customers away from the company, leading to further decrease in stock prices.

Discuss changes in demand for the company's products/services

Due to the loss of reputation and negative publicity, consumers may decide to boycott the company's products or services in protest against their unethical or illegal activities. This reduction in demand can lead to lower revenues and profits, which in turn may lead to a further decrease in stock prices.

Analyze the impact on future profitability

The combined effects of legal consequences, loss of investor confidence, and decline in demand for the company's products and services hinder the company's ability to generate profits in the long run, which is an important factor in evaluating stock prices. As a result, stock prices continue to plummet when a company is found guilty of unethical and illegal actions.

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