Question

You worked in a small local company as an assistant manager for several years. Now you quit the job and start your own business. You persuade your cousin to become a co-owner and invest $76,000 in the startup business. You invest $24,000 equity capital in the business. The business is organized as a limited liability company (LLC). You are the managing member, whereas your cousin is only a passive investor who does not manage the day-to-day operations. You also persuade your uncle to lend $20,000 to the business with 10% annual interest rate and 5-year term. To conserve cash, you agree not to take any salary in the first three years. Suppose you and your cousin are both in the 25% marginal personal income tax bracket.

Which of the followings is most likely to be a reasonable ownership structure of the new business? ____
a. You own 50%, your cousin owns 50%, and your uncle is not a co-owner.
b. You own 24%, your cousin owns 76%, and your uncle is not a co-owner.

c. you own 20%, your cousin owns 58.3%, and your uncle owns 16.7%.

d. You own 1/3, your cousin owns 1/3, and your uncle owns 1/3.

The after-tax interest cost (in annual percentage) of your uncle’s loan to your startup business is ____.
a. 2.5%
b. 7.5%

c. 10%

d. 12.5%

Suppose your cousin requires 40% ownership in exchange for the $76,000 investment. You agree this term. Then, the market value of your business’ equity is _____, and the book value of the equity is _____.

a. 190k; 100k

b. 190k; 120k

c. 100k; 100k

d. 120k; 120k

Which one of the following statements about you and your cousin is correct? _____.

a. Both you and your cousin have unlimited liability for the business.

b. You have unlimited liability but your cousin has limited liability for the business.

c. Your cousin has unlimited liability but you have limited liability for the business.

d. Both you and your cousin have limited liability for the business.

After the startup is launched, the following three years’ operating income is as follows:

Year 1: ‒$10,000; Year 2: +$30,000: Year 3: +$80,000
In these three years, your business distributed $0 (in year 1), $10,000 (in year 2) and $24,000 (in year 3) cash dividends to owners. The book value of your business’ equity at the end of the third year should be _____.
a. $100,000
b. $133,500
c. $160,000
d. $166,00

37. Suppose your cousin owns 40% of the business as a result of his initial $76,000 investment. At the end of the third year, an outside investor offers $200,000 for his ownership. Although your cousin likes this deal, you do not want to have this outside investor in your business. Which of the following statements is correct? ______

    1. Your cousin can freely sell his ownership to other people without your agreement, just as everybody can freely buy and sell the shares of public companies without other people’s permission.

    2. Unlike investing in public companies, your cousin cannot freely sell his ownership to other people without your agreement.

Answer 1

Q. no	Answer	Explanation
1	b. You own 24%, your cousin owns 76%, and your uncle is not a co-owner.	Total equity = 24000+76000 = 100000 and your share = 24000/100000 = 24%. Cousin's = 1-24% = 76%. Uncle is merely a lender
2	b. 7.5%	This is the after tax cost of debt i.e. 10%*(1-25%) = 7.5%
3	a. 190k; 100k	76000/0.4 = 190000. Book value = 24k+76k = 100k
4	d. Both you and your cousin have limited liability for the business.	In case of LLC all owners have limited liability.
5	d. $166,00	100,000 - 10,000 + 30,000 + 80,000 - 0 - 10,000 - 24,000 = 166,000
6	Unlike investing in public companies, your cousin cannot freely sell his ownership to other people without your agreement.	The LLC's operating agreement specifies any buy-sell provision that governs ownership transfers.