Question

Jupiter, Inc. is a U.S. corporation and the parent of a group of affiliated corporations. Some of the Jupiter subsidiaries are incorporated in foreign countries. Jupiter decided to restructure its international operations for both economic and tax reasons. Jupiter also wanted to use its overseas earnings more effectively and avoid using cash from its U.S. operations to fund overseas expansion. In order to accomplish these goals, Jupiter issued multi-million dollar “advance agreements” to its foreign subsidiaries in exchange for existing notes held by the subsidiaries. The advanced agreements had 40-year maturity dates and provided for a minimum interest rate that is in keeping with Jupiter’s credit position and current market rates. The holder could unilaterally extend an advance agreement for an additional 15 years. But, if a related party defaulted on such terms, an agreement maturity date would be voided, rendering the agreement perpetual. If the interest is not paid on an advance agreement, the lender had the right to immediate payment of all unpaid principal and accrued interest, or the immediate execution of a new 5-year advance agreement for the full amount of the accrued or unpaid interest. The advance agreements require that any obligation to pay the principal amount would be subordinated to all indebtedness of the new company (formed as part of the reorganization). Jupiter paid almost all of the amounts required to the holders of the advance agreements from the time of issuance until the end of 2017. There is nothing in the advance agreements to allow the holders (the subsidiaries) to demand immediate repayment in the case of Jupiter’s default. There was no change in ownership among the corporations as a result of the advance agreements. Jupiter has other outstanding debt owed its affiliates and all of that debt is ranked superior to any of the rights in the advance agreements. The interest payments on other outstanding notes receivable that Jupiter held would be used to make annual base payments on the advance agreements, but Jupiter contractually retained discretion on whether to actually do so. Jupiter’s debt-to-equity ratio after issuing the advance agreements went from 14 to 1 to 26 to 1.

a. You have been asked to evaluate, based on the information provided, whether the advance agreements are debt or equity. Discuss the various elements of debt and equity and evaluate how they apply to the advance agreements. Ignore the label and look at the elements of these items.

Answer 1

Ans:

Based on the above provided information advance agreements are debt.

The elements of debt are as follows which supports the answere.

1.) Interest Payments:

In Debt, company is obliged to pay some prefixed annual retrun in the form of interest whether fixed or variable for holding funds.

2.) Maturity Payments:

At the end of the contract of debt, company is obliged to repay the principal amount to the instruments holder.

3.) Compulsory Obligation to pay:

In Debt insruments, compay has to pay interest to the fund provider irrespective of the fact proftt or losses it had made during the year.

4.) Impact On Debt equity ratio

If a company issue debt instruments, it will increase it's debt equity ratio.

Debt equity ratio formula: Debt/Equity.

This formula shows that how many times comapny holds debt in compariosion to equity.

Application of these elements to adavnce agreements:

1.) Minimum interest payments: Company is obliged to pay minimum interest payments irrespective of it's which is the first element of debt.

2.) Maturity Paymnents: At maturity, company is obliged to return the principal amount which is also the feature of debt instruments but whereas in eqiuty it is the sole discretion of entity whether he wants to buy back its shares or not.

3.) Debt euity ratio: After issue of advance agreements, Debt equity ratio of comapny has increased from 14:1 to 26:1 which show that company is now financed more through debt in-comparision to equity.