Lesson Assignment #4: Corporations Capital Structure: Debt vs. Equity

Reading

Text: Study Chapter 4 of the Bittker and Eustice text.

Read: Paulsen v. CIR, 469 US 131 (1985).

Assignments

The following Assignments should be completed and submitted to the course faculty via the learning platform for evaluation and grading. Submit your responses to these questions in one WORD document. List the question first, and then your response.

Copy the question, and then provide your answer on all of the following:

LESSON 4, PROBLEM #1

Bill Jones has been referred to you by Pete Aaron, a local attorney. Bill is planning to commence a new business venture, Jones Online Resources (JOR). Due to the speculative nature of the proposed business, Aaron has recommended Jones operate the business under a new corporation to be formed by Aaron.

Jones will be the sole investor and expects to contribute $1,000,000 in cash to the venture. No other financing is expected at this time.

Jones has requested your advice on how to best structure the capital of the corporation. In a letter to Jones and Aaron explain the tax ramifications of the various alternatives for the capital structure of the corporation.

NOTE: This paper must be in the form of a letter using the guidelines typical for a business person.

LESSON 4, PROBLEM #2

ClydeCo has an annual net operating income of $1,500,000, 99,000 shares of stock outstanding, and no debt. ClydeCo pays federal income tax of $510,000 ($1.5 million multiplied by 34 percent), resulting in net after-tax income of $990,000 ($1.5 million lees $510,000). Earnings per share are $10 ($990,000 divided by 99,000 shares). The stock sells on the market at about

$80 per share (or 8 times earnings).

DonnorCo tenders for and acquires all of the outstanding ClydeCo stock for $120 cash per share, 50 percent more than the market price, for a total price of $11.88 million. DonnorCo puts up

$880,000 of its own funds and raises the remaining $11 million by issuing balloon notes paying 12 percent interest only for 10 years, to be assumed by ClydeCo. The annual net operating income of ClydeCo after the buyout is unchanged, except for debt service and taxes.

Complete the following chart showing the distribution of ownership of ClydeCos operating income before and after the leveraged buyout, using a 34 percent corporate tax rate:

ClydeCos original shareholders	Before $ 990,000	After -0-
Bondholders	-0-	$
DonnorCo	-0-	$
Corporate income taxes	$ 510,000	$

Total operating income $1,500,000 $1,500,000 Who has bene?ted from this transaction: the public sector or the private sector?

LESSON 4, PROBLEM #3

ConleyCo has 10 shareholders, each of whom owns 100 of its 1,000 outstanding shares of common stock (worth $100 per share). No other stock is outstanding. Determine whether the securities described in the situations below are debt or equity of ConleyCo.

ConleyCo issues a secured standard form note to the bank promising unconditionally to repay in five years $1 million borrowed, plus interest at the banks prime plus one percent.

ConleyCo issues to the public for cash $1 million worth of pure preferred stock (nonvoting, nonparticipating, nonconvertible), callable in five years at par, paying an

18 percent cumulative dividend. Would it matter if the stock were callable below par or had a declining dividend?

In return for a transfer of $1 million, ConleyCo issues an unsecured promissory note for $1 million to Mr. Murdock, well-known venture capitalist, payable in 10 years with interest keyed to ConleyCo's pro?tability. The note is subordinated to all other debt. ConleyCo could not have borrowed this amount on these terms from a bank.

ConleyCo issues to the public 1,000 notes for $1,000 each, maturing in 20 years, at which time the holder will be entitled to elect to receive either $600 cash or 50 shares of ConleyCo common stock. ConleyCo can call the notes for $600 after two years, but, upon call, the holder can convert to 50 shares of stock. Interest will be paid quarterly in an amount based on ConleyCos common dividend, but not less than $60 per annum. The interest rate for nonconvertible unsubordinated debt in the market is l2.percent. The notes will be subordinated to all other debt.

ConleyCo issues to the public $1 million in subordinated unsecured junk bonds, paying deferred interest resulting in an 18 percent yield to maturity, with all payments of principal and interest due in installments payable from the sixth to the fifteenth year.