In: Finance
Aristocrat, Baker, and Chef have formed Chez Guevara, Inc. (“Chez”) as a C corporation to operate a gourmet restaurant and bakery previously operated by Chef as a sole proprietorship. Aristocrat will contribute $80,000 cash, Baker will contribute a building with a fair market value of $80,000 and an adjusted basis of $20,000, and Chef will contribute $40,000 cash and the goodwill from his proprietorship with an agreed value of $40,000 and has a zero basis. In return, each of the parties will receive 100 shares of Chez common stock, the only class outstanding.
Chez requires at least $1,800,000 of additional capital in order to renovate the building, acquire new equipment, and provide working capital. It has negotiated a $900,000 loan from Friendly National Bank on the following terms: interest will be payable at two points above the prime rate, determined semi-annually, with principal due in ten years and the loan will be secured by a mortgage on the renovated restaurant building.
Instructions:
Evaluate the following alternative proposals for raising the additional $900,000 needed to commence business, focusing on the possibility that the Service will reclassify corporate debt instruments as equity.
Balance Sheet After taking Additional Capital (Option a): If the shareholders give loan to Corporate
Liabilities | Amount ($) (Adjusted Value) | Assets | Amount($) (Adjusted Value) | Fair Market Value($) |
Share Capital (300 Shares each) | 240000 |
Cash (Cash+ addtional working Capital) |
1920000 (140000+18000000) |
1920000 |
Additional Loan from Bank | 900000 | Building | 20000 | 80000 |
Additional Loan from Shareholders | 900000 | Goodwill | 0 | 40000 |
Total | 2040000 | 1940000 | 2040000 | |
The Debt-Equity Ratio will be 1800000:240000
180:24
Comment: Poor Debt:Equity Ratio and high risk.
Balance Sheet After taking Additional Capital (Option b): In this option, the shareholder recieve the interest only if the company get profit, hence it can be reclassified as equity
Liabilities | Amount ($) (Adjusted Value) | Assets | Amount($) (Adjusted Value) | Fair Market Value($) |
Share Capital (300 Shares each) | 240000 | Cash | 1920000 | 1920000 |
Additional Loan from Bank | 900000 | Building | 20000 | 80000 |
Additional Sharecapital from Shareholders | 900000 | Goodwill | 0 | 40000 |
Total | 2040000 | 1940000 | 2040000 | |
The Debt-Equity Ratio will be 900000: 1140000
90:114
Comment: Better Debt:Equity Ratio and less risk Hence preferable
Balance Sheet After taking Additional Capital (Option C): In this option, the shareholder have personal guarantee for the loan amount can be reclassified as equity
Liabilities | Amount ($) (Adjusted Value) | Assets | Amount($) (Adjusted Value) | Fair Market Value($) |
Share Capital (300 Shares each) | 240000 | Cash | 1920000 | 1920000 |
Additional Loan from Bank | 900000 | Building | 20000 | 80000 |
Additional Loan from Bank guaranteed by Shareholders | 900000 | Goodwill | 0 | 40000 |
Total | 2040000 | 1940000 | 2040000 | |
The Debt-Equity Ratio will be 900000: 1140000
90:114
Comment: Better Debt:Equity Ratio but high risk due to loan payable by corporate or shareholders Hence not preferable.
Balance Sheet After taking Additional Capital (Option d): All Loan from Aristocraft
Liabilities | Amount ($) (Adjusted Value) | Assets | Amount($) (Adjusted Value) | Fair Market Value($) |
Share Capital (300 Shares each) | 240000 | Cash | 1920000 | 1920000 |
Additional Loan from Bank | 900000 | Building | 20000 | 80000 |
Additional Loan from Aristocraft | 900000 | Goodwill | 0 | 40000 |
Total | 2040000 | 1940000 | 2040000 | |
The Debt-Equity Ratio will be 1800000:240000
180:24
Comment: Debt-Equity Ratio is still high and high risk. Not preferable
Part E: In the case of non-payment of interest, the action depends upon the terms agreed between corporate and Aristocraft. As the case may be, Aristocraft can file the suit against the corporate for paying his interest.