Aristocrat, Baker and Chef have formed Chez Guevara, Inc.

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.

Evaluate the following alternative proposals for raising the additional $900,000 needed to commence business, focusing on the possibility that the IRS will reclassify corporate debt instruments as equity.

ONLY ANSWER (b)

(a) 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.

(b) Same as (a), 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.