Question

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.

1. Aristocrat, Baker, and Chef each will loan Chez $300,000, and each will take back a $300,000 five-year corporate note with variable interest payable at one point below the prime rate, determined annually.

2. Same as (a) above, except that each of the parties will take back $300,000 of 10% 20-year subordinated income debentures; interest will be payable only out of the net profits of the business.

3. Same as (a) above, except that the $900,000 loan from Friendly National Bank will be unsecured but personally guaranteed by Aristocrat, Baker, and Chef, who will be jointly and severally liable.

4. Aristocrat will loan the entire $900,000, taking back a $900,000 corporate note with terms identical to those described in (a) above.

5. Same as (d) above, except that commencing two years after the incorporation, Chez ceases to pay interest on the notes because of severe cash flow problems.

Answer 1

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.