Chapter Review
13-9iCases & Projects
Ethics in Action
Tommy Gunn is a division manager for K-Cern Inc., a small pharmaceutical company. Tommy’s division has been working on a new drug that has the potential to revolutionize the treatment of skin cancer. Once the drug is proven to be effective in clinical trials, it will be approved for sale by the government and patented by the company. Because of the potential market for this drug, it is highly likely that the company’s revenues and net income will increase significantly when it is approved. Tommy recently saw an internal company memo indicating that the drug passed its final clinical trial and that the company has received government approval to sell the drug. The company will issue a press release announcing this news in the next two days, and this announcement is expected to result in a dramatic increase in the company’s stock price. Tommy knows that there is “free money” to be made if he invests in the stock before the announcement is made. However, K-Cern has a strict policy against employee purchases of company stock outside of established employee stock purchase plans. To get around this rule, Tommy asks his father to purchase the stock for him. The next morning Tommy’s father purchases the stock with the understanding that he will split the profits with Tommy.
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Is Tommy behaving ethically? Why or why not?
Ethics in Action
Lou Hoskins and Shirley Crothers are organizing Red Lodge Metals Unlimited Inc. to undertake a high-risk gold-mining venture in Canada. Lou and Shirley tentatively plan to request authorization for 400,000,000 shares of common stock to be sold to the general public. Lou and Shirley have decided to establish par of $0.03 per share in order to appeal to a wide variety of potential investors. Lou and Shirley believe that investors would be more willing to invest in the company if they received a large quantity of shares for what might appear to be a “bargain” price.
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Discuss whether Lou and Shirley are behaving in a professional manner.
Team Activity
In teams, select a public company that interests you. Obtain the company’s most recent annual report on Form 10-K. The Form 10-K is a company’s annually required filing with the Securities and Exchange Commission (SEC). It includes the company’s financial statements and accompanying notes. The Form 10-K can be obtained either (a) by referring to the investor relations section of the company’s website or (b) by using the company search feature of the SEC’s EDGAR database service found at www.sec.gov/edgar/searchedgar/companysearch.html.
Based on the information in the company’s most recent annual report, determine the following:
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Name of the corporation
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State of incorporation
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Nature of its operations
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Total assets reported on the most recent balance sheet
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Total liabilities reported on the most recent balance sheet
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Total stockholders’ equity reported on the most recent balance sheet
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Total revenues reported on the most recent income statement
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Net income reported on the most recent income statement
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The number of shares of common stock authorized, issued, and outstanding
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The par value per share of each class of stock
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Basic and diluted earnings per share reported on the income statement
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Dividend per share reported on the income statement
Communication
Motion Designs Inc. has paid quarterly cash dividends since 20Y7. These dividends have steadily increased from $0.05 per share to the latest dividend declaration of $0.50 per share. The board of directors would like to continue this trend and is hesitant to suspend or decrease the amount of quarterly dividends. Unfortunately, sales dropped sharply in the fourth quarter of 20Y8 due to worsening economic conditions and increased competition. As a result, the board is uncertain as to whether it should declare a dividend for the last quarter of 20Y8.
On October 1, 20Y8, Motion Designs Inc. borrowed $4,000,000 from Valley National Bank to use in modernizing its retail stores and to expand its product line in response to changes in its industry. The terms of the 10-year, 6% loan require Motion Designs to do the following:
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Pay monthly interest on the last day of the month
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Pay $400,000 of the principal each October 1, beginning in 20Y9
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Maintain a current ratio (current assets ÷ current liabilities) of 2
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Maintain a minimum balance (a compensating balance) of $100,000 in its Valley National Bank account
On December 31, 20Y8, $1,000,000 of the $4,000,000 loan had been disbursed in modernization of the retail stores and in expansion of the product line. Motion Designs Inc.’s balance sheet as of December 31, 20Y8, follows:
The board of directors is scheduled to meet January 10, 20Y9, to discuss the results of operations for 20Y8 and to consider the declaration of dividends for the fourth quarter of 20Y8. The chairman of the board, Matt Cengage, has asked for your advice on the declaration of dividends.
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Write a brief memo to the chairman of the board, outlining the factors that the board should consider in deciding whether to declare a cash dividend.
Ethics in Action
Bernie Ebbers, the CEO of WorldCom, a major telecommunications company, was having personal financial troubles. Ebbers pledged a large stake of his WorldCom stock as security for some personal loans. As the price of WorldCom stock sank, Ebbers’s bankers threatened to sell his stock in order to protect their loans. To avoid having his stock sold, Ebbers asked the board of directors of WorldCom to loan him nearly $400 million of corporate assets at 2.5% interest to pay off his bankers. The board agreed to lend him the money.
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Comment on the decision of the board of directors in this situation.
Issuing Stock
Epstein Engineering Inc. began operations on January 5, 20Y8, with the issuance of 500,000 shares of $80 par common stock. The sole stockholders of Epstein Engineering Inc. are Barb Abrams and Dr. Amber Epstein, who organized Epstein Engineering Inc. with the objective of developing a new flu vaccine. Dr. Epstein claims that the flu vaccine, which is nearing the final development stage, will protect individuals against 90% of the flu types that have been medically identified. To complete the project, Epstein Engineering Inc. needs $25,000,000 of additional funds. The local banks have been unwilling to loan the funds because of the lack of sufficient collateral and the riskiness of the business.
The following is a conversation between Barb Abrams, the chief executive officer of Epstein Engineering Inc., and Amber Epstein, the leading researcher:
What are we going to do? The banks won’t loan us any more money, and we’ve got to have $25 million to complete the project. We are so close! It would be a disaster to quit now. The only thing I can think of is to issue additional stock. Do you have any suggestions?
I guess you’re right. But if the banks won’t loan us any more money, how can we find any investors to buy stock?
I’ve been thinking about that. What if we promise the investors that we will pay them 5% of sales until they receive an amount equal to what they paid for the stock?
What happens when we pay back the $25 million? Do the investors get to keep the stock? If they do, it’ll dilute our ownership.
How about if after we pay back the $25 million, we make them turn in their stock for $120 per share? That’s one and one-half times what they paid for it, and they would have already gotten all their money back. That’s a $120 profit per share for the investors.
It could work. We get our money but don’t have to pay any interest, dividends, or the $80 per share until we start generating sales. At the same time, the investors could get their money back plus $120 per share profit.
We’ll need current financial statements for the new investors. I’ll get our accountant working on them and contact our attorney to draw up a legally binding contract for the new investors. Yes, this could work.
In late 20Y8, the attorney and the various regulatory authorities approved the new stock offering, and 312,500 shares of common stock were privately sold to new investors at the stock’s par of $80.
In preparing financial statements for 20Y8, Barb Abrams and Dan Fisher, the controller for Epstein Engineering Inc., have the following conversation:
Barb, I’ve got a problem.
What’s that, Dan?
Issuing common stock to raise that additional $25 million was a great idea. But…
But what?
I’ve got to prepare the 20Y8 annual financial statements, and I am not sure how to classify the common stock.
What do you mean? It’s common stock.
I’m not so sure. I called the auditor and explained how we are contractually obligated to pay the new stockholders 5% of sales until $80 per share is paid. Then we may be obligated to pay them $120 per share.
So…
So the auditor thinks that we should classify the additional issuance of $25 million as debt, not stock! And if we put the $25 million on the balance sheet as debt, we will violate our other loan agreements with the banks. And if these agreements are violated, the banks may call in all our debt immediately. If they do that, we are in deep trouble. We’ll probably have to file for bankruptcy. We just don’t have the cash to pay off the banks.
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Discuss the arguments for and against classifying the issuance of the $25 million of stock as debt.
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What might be a practical solution to this classification problem?