Ethical issues of managing income and the debt-equity ratio through hond retirement.

Suppose thai Quaker Oats Company issued $40 million of 5-percenl semiannual coupon bonds main years ago at par. The bonds now have 20 years until scheduled maturity. Because market interest rates have risen to 9 percent, the market value of the bonds has dropped to 63 percent o( par. Quaker Oats has $5 million o\' current liabilities and $3? million of shareholders" equity in addition to the $40 million oi' long-term debt in its financial structure. The debt-equity ratio

(= total liabilities/total liabilities plus shareholders' equity) is 56 percent |= ($40 + $5)/($5 +

$40 + $35)]. (Shareholders' equity includes an estimate of the current year's income.) The pres- ident of Quaker Oats is concerned about boosting reported income for the year, which is about

$8 million in the absence of any other actions. Also, the debt-equity ratio appears to be larger than that o( other firms in the industry. The president wonders what the impact on net income and the debt-equity ratio would be if the company issues at par new 9-percent semiannual coupon bonds to mature in 20 years and uses the proceeds to retire the outstanding bond issue.

Assume that such action is taken and that any gain on bond retirement is taxable immediately, at the rate of 40 percent.

a. Prepare the journal entries for the issue of new bonds in the amount required to raise funds to retire the old bonds, for the retirement of the old bonds, and for the income tax effects.

b. What is the effect on income for the year? Give both dollar and percentage amounts.

c. What is the debt-equity ratio after the transaction?

d. Discuss any ethical concerns raised by these considerations.