Ethics Case :
Bricker Graphics is a privately held company whose profitability has been sharply dropping. The COO, Don Benson, has been under serious fire for not reaching the company's performance goals of achieving a return on assets of 12% or higher. Don Benson went on a business trip to Switzerland to discuss a custom-made machine with a Swiss firm that he believes could turn his company around. He seems dead set on acquiring this new custom-made machine, and called the Controller, Susan Sharp, into his office. He brings up the two ways that the company could acquire this machine- debt financing of $12,500,000 at the current market rate of interest, or issuing shares of common stock for $10,000,000. Sharp notes that "we agreed" that debt is the way to go, but Don Benson prefers equity financing, because that would better help their rate of return on assets.
The rate of return on assets is calculated by dividing net income over total assets (or average total assets). Net Income/Total Assets (Average Total Assets). There are a couple ways that using equity financing over debt financing would boost this ratio in the following period. If Bricker Graphics used debt financing, they would receive $12,500,000. There would be no discount or premium for the bonds, because the bond is issued as the current market rate of interest. If Bricker Graphics used equity financing, they would receive $10,000,000. While cash flow would be more favorable on the onset with issuing the bond, this would increase the company's assets. This would hurt the company's return on assets because the denominator would be a higher number- conceptually, because it cost more assets to get that net income. If the company's net income was 10 million dollars, and their only asset was the 10 million dollars of cash from the equity sale, their return on assets would be 100%. (10/10) If the company's net income was 10 million dollars, but their asset was the 12.5 million dollars from the bond sale, their return on assets would only be 80%. (10/12.5). (This would not be practical of course- a company could not survive or even exist if cash from a bond/equity sale was their only asset, but it does prove the point for calculation purposes).
Another way that equity financing would boost the return on assets ratio is that net income would be higher for the following period. This is because there would be no interest expense from the bonds. Interest expense lowers net income, and thus would lower the numerator of this equation. For example, if the interest rate for this bond was 8%, the interest expense for this period would be 1 million dollars. Instead of a net income of 10 million dollars, there would be a net income of 9 million dollars- (10-1). The return on assets would be 72%.
Because of these factors, equity financing would result in a higher rate on return on assets.
Issuing shares of stock to fund operations and grow business is an extremely common practice. Most medium and large companies use a mix of debt and equity funding. In fact, only 10 out the S&P 500 companies are debt free. (Ni, Chu, & Li, 2017) How a business chooses to fund and what mix it uses is referred to as a company's ‘capital structure'. As long as the business abides by the proper and necessary laws, issuing additional shares of stock is not an ethically or morally dubious thing in and of itself. However, I believe that as Christians, we are called to a higher ethical standard than just "following the laws". Issuing additional shares of common stock will hurt the existing stockholders. Their interests and power in the company will be diluted if other prospective shareholders have an ownership stake in the company. If the current shareholders all purchase the 10 million dollars of additional stock according to their current ownership percentage, then their ownership stake will not be diluted. This forces the current shareholders to invest more money into the company of course, which the shareholders might not want to do. I would recommend that Don Benson talk to the Board of Directors about his plan, especially because his Controller says that "we agreed that debt is the way to go". Isaiah 29:15 (ESV) says "Woe to those who deeply hide their plans from the Lord. And whose deeds are done in a dark place, And they who say "Who sees us?" or "Who knows us?" Don Benson should not hide his actions from the Board of Directors. In my experience, whenever I strive to hide something, it is because of shame or fear of being corrected. If I conceal something, it is because I don't want other people to know about it. I believe that if Don Benson does not reveal his plans to shareholders, he is trying to sinfully deceive them in order to protect his own job status. Depending on the company bylaws, Don Benson may not have the authority to issue additional shares, which is another reason for him to be open about his proposals. (Walther, 2015) I advise him to seek counsel and share his ideas with others instead of making a unilateral decisions and blindsiding shareholders, who are ultimately in charge of the company. He is accountable to the Board of Directors, who are chosen by the shareholders.
Reference:
Ni, J., Chu, L. K., & Li, Q. (2017). Capacity decisions with debt financing: The effects of agency problem. European Journal of Operational Research, 261(3), 1158-1169.
Walther, B. (2015). Bylaw Governance. Fordham Journal of Corporate & Financial Law, 20(2), 399-459.