Nate Smith and Darla Jones have written a smartphone app. They need additional capital to market the app, so they plan to incorporate their business. Smith and Jones are considering alternative capital structures for the corporation. Their primary goal is to raise as much capital as possible without giving up control of the business. Smith and Jones plan to receive 50,000 common shares of the corporation in return for the net assets of their old business. After the old company's books are closed and the assets adjusted to current fair value, Smith's and Jones's capital balances will each be $25,000.
The company's incorporation plans include an authorization to issue 10,000 preferred shares and 500,000 common shares. Smith and Jones are uncertain about the most desirable features for the preferred shares. Prior to incorporating, Smith and Jones are discussing their plans with two investment groups. The corporation can obtain capital from outside investors under either of the following plans:
• Plan 1. Group 1 will invest $80,000 to acquire 800 $6, non-voting preferred shares.
• Plan 2. Group 2 will invest $55,000 to acquire 500 $5 preferred shares and $35,000 to acquire 35,000 common shares. Each preferred share receives 50 votes on matters that come before the shareholders.
Requirements
Assume that the company is incorporated.
1. Journalize the issuance of common shares to Smith and Jones. Debit each person's capital account for its balance.
2. Journalize the issuance of shares to the outsiders under both plans.
3. Assume that net income for the first year is $120,000 and total dividends are $30,000. Prepare the shareholders' equity section of the corporation's balance sheet under both plans.
4. Recommend one of the plans to Smith and Jones. Give your reasons.