Muddy Water Inc. catches and supplies fresh seafood to a variety of restaurants across
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ETHICAL DILEMMA Muddy Water Inc. catches and supplies fresh seafood to a variety of restaurants across the country. While the company remains profitable, increased competition from South American seafood suppliers has lowered the company’s return on equity (Net Income 4 Average Shareholders’ Equity) to a level that the board of directors finds unacceptable. In response to these competitive pressures, the company decides to modernize its processing plants in hopes that the resulting increase in efficiency will lead to lower costs and higher profit margins. You are in charge of assembling a team to develop financing options. After carefully analyzing the various options, your team recommends that the modernization be financed by issuing stock. The CEO, however, discusses the matter with another business professional who informs her that issuing stock would only increase shareholders’ equity, which would lower the company’s return on equity, while debt financing might actually help the company reach its return on equity targets. The CEO now advocates financing the modernization with debt instead of equity. While you confirm that this may be true, you inform the CEO that the debt option is much riskier, and the required interest payments would lower the company’s net income and put the company in a shaky cash position. The CEO states that she understands the risk, but that she really needs to reach the return on equity target to achieve bonuses for her executive team, and any cash flow concerns will not surface until after she retires in 2 years. Do you have any ethical responsibilities to report the CEO’s decision to the board of directors? |
Here is a tip:
Debt financing has a tax advantage, but it increases the level of leverage.
Explanation
The return on equity will decrease when additional shares are issued, but the financial risk increases with an increase in the debt capital.
Debt capital requires mandatory and timely interest payments, unlike equity capital. The net income will decrease as a result of increased interest payments.
The suggestion of the CEO is wrong and also unethical because she is concerned about the activities of the company only for her tenure of 2 years. Debt financing may increase the return on equity ratio but will affect several other profitability and leverage ratios.
This will adversely affect the financial results and financial position of a company, and therefore, the situation should be reported to the board of directors.
Verified Answer
Yes.
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