Discuss any ethical issues raised by the following actions. Lamb Inc has a debt-equity ratio of 30 percent, which is considerably lower than most of its competitors. Lamb Inc has become the target of a takeover by a group of outside investors. This

Question

takeover group feels that Lamb Inc could service debt up to 60 percent of its financing. They plan to borrow the necessary cash to finance the takeover and then have Lamb Inc assume the debt. This action will result in a debt-equity ratio for Lamb Inc of 60 percent after the takeover. The current management desires to defend Lamb Inc against this takeover attempt. It sells off a profitable division of the business and uses the cash proceeds to buy back outstanding common stock. This action has the effect of increasing the debt-equity ratio to 60 percent, making Lamb Inc less attractive because of the sale of the profitable division, and increasing the stock price that the takeover group must pay.

Answer 1

Ethical issues confront the Lamb Inc. management when they made the decision to sell off a profitable division of the business and use the cash proceeds to buy back outstanding common stock. Lamb Inc. management should examine (1) whether the action violates a known law or regulation and (2) whether Lamb provided sufficient disclosure about the action for the users of financial statements to make their own judgments about the ethics of such actions. The measurement and reporting of the effect of increasing the debt-equity ratio to 60 percent, making the firm less attractive because of the sale of the profitable division, and increasing the stock price that the takeover group must pay conforms with GAAP. Some may argue that an ethical issue does not arise as long as Lamb Inc. provided sufficient disclosures for a user to make informed decisions. Other people would argue that an ethical issue arises because management took an action for the primary purpose of making Lamb Inc.less attractive, and increasing the stock price that the takeover group must pay. Management purposefully managed, some would say distorted, increasing the debt-equity ratio to 60 percent and may have decreased, rather than increased, shareholder value resulting in a net economic loss to the shareholders.