Question

1. Pokes Inc. is a C corporation that sell Western apparel, including cowboy hats and boots. Pokes has two equal shareholders, Pistol and Pete. Pokes needs $2,000,000 of additional capital to renovate its retail store and provide working capital. Pokes has acquired a $1,000,000 loan from Sooner National Bank. For the additional $1,000,000 of capital needed, Pistol and Pete have each agreed to loan Pokes $500,000 in exchange for a 5-year corporate note, with interest payable only out of the net profits of the corporation.

A balance sheet for Pokes Inc., following the receipt of the two loans, is provided below. Assume that the fair market value of each asset equals its adjusted basis.

Pokes, Inc.
Balance Sheet
Assets:			Liabilities:
Cash	$2,200,000		Bank Loan	$1,000,000
Inventory	80,000		Shareholder Loans	$1,000,000
Building	100,000		Total Liabilities	$2,000,000
Total Assets	$2,380,000
			Stockholders' Equity:
			Common Stock	$380,000
			Total Stockholders' Equity and Liabilities	$2,380,000

Instructions:

1. Explain whether the loans made by Pistol and Pete to Pokes Inc. should be classified as debt or equity financing based on each of the following common law factors. Note: You must decide whether each factor suggests either debt or equity classification. Bifurcation is not an option.

The debt/equity ratio (show inside and outside ratio calculations):

Form:

Proportionality:

Answer 1

a.

Formula for Debt-equity ratio = Outsidfers Funds / Shareholders Funds

= Short term and long term loans / shareholders equity

Total loan from outsiders = Loan from Sooner Nationl bank = $1,000,000

Add:Loan from Pistol and Pete = $1,000,000

------------------------

Total Lon = $2,000,000 ------------ A

--------------------------

Shareholder's equity is the common stock = $380,000 ---------------- B

Debt - Equity Ratio is A / B = 2,000,000 / 380,000 = 5.26 (rounded of to 2 decimal places)

This indicates higher proportion of debt compared to that of equity, that owners or shareholders contibution to cap[ital is less and loans or funds from outsde is more than equity. So greater the D / E ratio, greater is the risk to creditors.

Regarding the classification of loan given by pistol and pete as debt or equity:

Their loan to Pokes is a debt, which means long term financing provided by them to pokes, This debt falls under the category of junior debt as the priority for repayment is lower (as it is loan provided by shareholders but not from outsiders or creditors).