Depinder Singh is a friend of yours who has worked at a number of restaurants. He has always wanted to own his own business and his dream can now come true because he just won $1 million in a lottery. There are two restaurants (one is small and one is large) currently operating that are available for purchase on January 1. Regardless of which one he buys, Depinder will set up a business that will have a December 31 year end. The business will be financed with his winnings from the lottery and the business will then buy all of the assets of one of the two restaurants. Depinder is not sure if the money he puts into the business should consist completely of debt or equity. He believes that the assets will cost $1 million for the small restaurant or $2 million for the large restaurant. Revenues for the first year are expected to be equal to the value of the assets purchased. Operating expenses are expected to be 85% of sales, and the corporate income tax rate calculated at 25% of profit before income tax. Interest on any loans (whether from Depinder or from the bank) will be 6% and any profit earned by the corporation will be paid out as dividends.

Depinder needs your help in assessing the following three options:

1. His business is formed as a corporation with $1 million of common shares and no debt. The assets of the small restaurant are then purchased by the business.

2. His business is formed as a corporation with $1 of common shares and a $999,999 loan from Depinder. The assets of the small restaurant are then purchased by the business.

3. His business is formed as a corporation with $1 million of common shares and a $1-million loan from the bank. The assets of the large restaurant are then purchased.

Instructions

(a) For each of the three options listed above, prepare the income statement that you would expect to see for the first year of the company's operations.

(b) Calculate the return on common shareholders' equity for the first year for each option above. Which option results in the best return? Explain why.

(c) Based on your results in part (a) above, how much cash (before personal income tax) would Depinder have personally (not in the corporation) under each option if all of the profit earned by the company is paid out to him at the end of the year as a dividend?

(d) Without calculating any amounts, what do you think would happen to the return on common shareholders' equity if the operating expenses were 110% of revenue and the company suffered a loss? Would the return be better or worse if the company had more debt?

(e) Without calculating any amounts, how would the income statement change if Depinder did not borrow $1 million from the bank, but obtained those funds from an uncle who bought preferred shares in the corporation and wanted a 5% dividend yield?

(f) Following from part (e) above, if the uncle insisted on being able to sell the preferred shares back to the company at a time of his (the uncle's) choosing, would the preferred shares be classified as debt or equity on the statement of financial position?

(g) Without doing any calculations, if Depinder bought the small restaurant, operated it as a proprietorship rather than incorporating it, and did not borrow any money, how would the projected income statement change from that indicated in your answer to Option 1 in part (a) above?