Question

Paula Green owns and operates the Green Thumb Nursery as a sole proprietorship. The business has total assets with a $260,000 adjusted basis and a $500,000 FMV. Paula wants to expand into the landscaping business. She views this expansion as risky and therefore wants to incorporate so as not to put her personal assets at risk. Her friend, Mary Brown, is willing to invest $250,000 in the enterprise.

Although Green Thumb has earned approximately $55,000 per year, Paula and Mary expect that, when the landscaping business is launched, the new corporation will incur annual losses of $50,000 for the next two years. They expect profits of at least $80,000 annually, beginning in the third year. Paula and Mary earn approximately $50,000 from other sources. They are considering the following alternative capital structures and elections:

1. Green Thumb issues 50 shares of common stock to Paula and 25 shares of common stock to Mary.

2. Green Thumb issues 50 shares of common stock to Paula and a $250,000 ten-year note bearing interest at 8% to Mary.

3. Green Thumb issues 40 shares of common stock to Paula plus a $100,000 ten-year note bearing interest at 6% and 15 shares of common stock to Mary, plus a $100,000 ten-year note bearing interest at 6%.

4. Green Thumb issues 50 shares of common stock to Paula and 25 shares of preferred stock to Mary. The preferred stock is nonparticipating but pays a cumulative preferred dividend at 8% of its $250,000 stated value.

What are the advantages and disadvantages of each of these alternatives? What considerations are relevant for determining the best alternative?

Answer 1