Intermediate Accounting Reporting and Analysis 3rd Edition

HOW IS THE CAPITAL STRUCTURE OF A CORPORATION DEFINED?,

ETHICAL DIL EMMA 15-9

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 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 anlyzing 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 shareholder's equity, which would lower the compny'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?