Success Systems started on October 1, 2013 and has been successful to the point

Question

Success Systems started on October 1, 2013 and has been successful to the point that they plan to expand. The owner believes that an additional $86,000 is needed and is investigating three funding sources.

a. The owner's sister is will ing to invest $86,000 in the business as a common shareholder. Since the owner has about $129,000 invested in the business, the sister's investment will mean that the owner will maintain about 60% ownership and the sister will have 40% ownership.

b. The owner's uncle is willing to invest $86,000 in the business as a preferred shareholder. He would purchase 860 shares of $100 par value, 7% preferred stock.

c. The owner's banker is willing to lend $86,000 on a 7%, 10-year note payable. The owner would make monthly payments of $1,000 per month for 10 years.

Required:

1. Prepare the journal entry to reflect the initial $86,000 investment under each of the options, a, b, and c.

2. Evaluate the three proposals for expansion, providing the pros and cons of each option.

3. Which option do you recommend that the owner adopts? Why?

Explanation / Answer

1 journal entry

A. Money received from common share holder

Debit cash $86000

Credit paid in capital. 86000

B. Money received from preference shareholders

Debit cash $86000

Credit preference share capital. $86000

C. Money received from Bank as notes payable

Debit cash $ 86000

Credit notes payable. $86000

2

. Issue of common share

Prons ;

A . Not to pay back in its life time.

B does not carry any fixed burden of dividends

C. Risk is divided between shareaolders

Cons;

A. Control is diluted

B. Solution of earnings takes place as no of share holders increased.

Issue of preference share

A. Protected from dilution of control

B protected from dilution of earnings as dividends are fixed

C increase the flexibility in capital structure.

Cons

A. Carry the fixed burden

B cistly as compared to debt source

Issue if notes payable

Prons ,

Does not dilute the ownership

Interest payments are tax deductible

Flexible capital structure can be maintained.

Cons

Have to pay back after the fixed period

Intrest have to be paid whether there is profit in business or loss.

3. I will recommend debt source of financing as it cost is less from the other sources of finance. More ever we can pay it back , in a fixed period.

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