Cliff Dennis may become a rich man. He is the creative force behind Amazing Drives, a new company. Amazing makes external drives that permit computer users to store large amounts of information on small floppy diskettes. Amazing has experienced tremendous growth since its inception three years ago. Investors have recognized the company’s potential, and its stock is currently selling at 60 times projected earnings. More specifically, the company’s 2009 earnings forecast shows estimated income to be $0.30 per share and the current market price is $18 per share ($0.30 × 60). Mr. Dennis has stock options permitting him to buy 2,000,000 shares of stock for $12 per share on January 1, 2010. This means that he could earn $6 per share on the options. In other words, he would buy the stock at $12 per share and sell it at $18 per share. As a result, Mr. Dennis would earn $12,000,000 ($6 × 2,000,000 shares).
Unfortunately, weak economies in foreign countries have caused low demand for Amazing’s products in international markets. Company insiders are painfully aware that Amazing Drives is going to be unable to meet its projected income numbers. If actual earnings fall short of the projected earnings, the market will manifest its disappointment by discounting the stock price. Mr. Dennis is concerned that the value of his stock options could plummet.
At its inception three years ago, Amazing invested heavily in manufacturing equipment. Indeed, expecting dramatic growth, the company purchased a significant amount of excess capacity. As a result, the company incurs approximately $28,800,000 in fixed manufacturing costs annually. If Amazing continues to produce at its current level, it will make and sell approximately 800,000 drives during 2009. In the face of declining sales, Mr. Dennis has issued a puzzling order to his production manager. Specifically, he has told the production manager to increase production so that 1,200,000 drives will be completed during 2009. Mr. Dennis explained that he believes the economies in foreign countries will surge ahead in 2010 and that he wants Amazing to have the inventory necessary to satisfy the demand.
Required
a. Suppose that actual earnings for 2009 are $0.18 per share. The market becomes disappointed, and the price-earnings ratio falls to 40 times earnings. What is the value of Mr. Dennis’s stock options under these circumstances?
b. Determine the impact on income reported in 2009 if production is 800,000 units versus 1,200,000 units.
c. Why would Mr. Dennis order the increase in production?
d. Does Mr. Dennis’s behavior violate any of the standards of ethical conduct in Exhibit 1.15 of Chapter 1?
e. Identify the features described in this case that could motivate criminal and ethical misconduct. (It may be helpful to reread the fraud triangle in Chapter 1 before attempting to satisfy this requirement.)