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 income before income tax. Interest on any loans (whether from Depinder or from the bank) will be 6% and any net income 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.

CT11-4 Reporting & Analyzing Shareholders Equity

Option #1		Option #2		Option #3
$1 million common shares		$1 common shares		$1 million common shares
No debt		$999,999 loan		$1 million loan
$1 million in assets		$1 million in assets		$2 million in assets

Part one:

(a) For each of the three options listed above, prepare the statement of income that you would expect to see for the first year of the companys 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 net income earned by the company is paid out to him at the end of the year as a dividend?