Comprehensive Problem 4 Corporations Part 1 Jump In Jehovahs

Comprehensive Problem 4 Corporationspart 1jumpinjehosaphats Is A Small

Comprehensive Problem 4 involves two main parts: preparing the stockholder’s equity section of the balance sheet upon incorporation and analyzing methods of raising additional capital for the corporation.

In the first part, JumpinJehosaPhats is a sole proprietorship owned by JJ Phats that is being incorporated. As of January 1, 2012, the corporation is authorized to issue 1,000,000 common shares with a par value of $1.00. Since the business is changing from sole proprietorship to corporation, the owner's equity accounts from the sole proprietorship must be closed, and the new stockholders' equity section must be prepared. The books for the sole proprietorship show that JJ Phats deposited $35,000 to start the business and contributed equipment valued at $50,000. Additionally, the retained earnings as of December 31, 2011, are $150,000. The task is to prepare the stockholder’s equity portion of the balance sheet as of January 1, 2012, reflecting these changes and the new corporate structure.

In the second part, JumpinJehosaPhats seeks to raise $10,000,000 for expansion purposes one year after incorporation. JJ Phats is the sole shareholder interested in funding this expansion. The company is evaluating three methods: issuing common shares at fair market value (FMV), issuing preferred stock with a par value of $1,000, or issuing 10-year bonds with a par value of $1,000. The details provided include that the company is authorized to issue 1,000,000 shares at a par value of $1 each, and an appraisal on January 1, 2013, values the company at $25 million. Current interest rates are approximately 3.5% APR, which are increasing, and as a benchmark, on December 1, 2012, a competitor issued preferred shares at 3.4% at par value of $1,000 for 10 years.

The second part requires an assessment of the pros and cons of each funding method, supported by relevant calculations, to determine the most strategic approach (single method or combination) for raising the needed capital while considering factors such as cost, ownership dilution, timing, and risk.

Paper For Above instruction

In the process of transforming a sole proprietorship into a corporation, understanding the implications on owner’s equity and capital raising strategies is essential for business growth and stability. This paper discusses the initial recording of stockholders' equity upon incorporation of JumpinJehosaPhats and evaluates optimal methods for raising additional capital to support expansion efforts, considering the current economic climate and market conditions.

Part 1: Stockholders’ Equity at Incorporation

When JJ Phats transitioned JumpinJehosaPhats from a sole proprietorship to a corporation on January 1, 2012, the owner’s equity accounts from the sole proprietorship needed to be closed, and new stockholders’ equity accounts created. The initial investments made by JJ Phats included a cash deposit of $35,000 and equipment valued at $50,000, reflecting assets contributed by the owner at the time of incorporation. The retained earnings from previous operations amounted to $150,000, which must be transferred into the retained earnings account of the new corporation.

The total contributed capital comprises the cash and equipment contributed by JJ Phats. Since the equipment is an asset, it should be recorded at its fair market value on incorporation. Given the information, the total assets contributed are $35,000 (cash) + $50,000 (equipment), totaling $85,000. This amount, along with the retained earnings of $150,000, forms the basis of the stockholders’ equity section.

Assuming all initial contributions are recognized as common stock at par value, with 1,000,000 authorized shares at $1 par value, the initial common stock issued will be based on the amount of cash contributed. Not all the contributed assets need to be reflected directly as stock; however, the initial owner’s equity will be summarized as follows:

• Common Stock: 35,000 shares issued at $1 par = $35,000
• Additional paid-in capital: (if any)—since the assets contributed exceed the common stock par value, the excess is recorded as additional paid-in capital. In this case, the total assets contributed ($85,000) minus the common stock par value ($35,000) leaves $50,000, which can be allocated to additional paid-in capital.
• Retained Earnings: $150,000 as of December 31, 2011, transferred into the new corporation’s retained earnings account.

Thus, the initial stockholders’ equity on the balance sheet as of January 1, 2012, would be summarized as follows:

• Common Stock: $35,000
• Additional Paid-in Capital: $50,000
• Retained Earnings: $150,000

Total Stockholders’ Equity: $235,000

This reflects the equity structure after incorporation, capturing the owner’s contributions, retained earnings, and the issuance of shares.

Part 2: Raising Capital for Expansion

For the company's expansion needs of $10 million, three main funding options are considered: issuing common shares, preferred stock, or bonds. Each has distinct advantages and disadvantages, which must be evaluated in light of the company’s valuation, market conditions, and the cost of capital.

Issuing Common Shares at Fair Market Value

This method involves selling new shares at the current valuation of $25 million, as appraised on January 1, 2013. The number of shares to be issued is calculated based on the proportional ownership that would just satisfy the $10 million capital requirement:

Number of Shares = $10,000,000 / ($25,000,000 / 1,000,000 shares) = 400,000 shares

Equity dilution occurs as existing shareholders’ ownership percentage decreases. However, this method does not incur debt and does not require fixed interest payments, which preserves cash flow but potentially dilutes ownership control.

Issuing Preferred Stock

The preferred stock proposed has a par value of $1,000 and offers cumulative dividends based on a 3.4% rate, similar to the competitor’s offering. In raising $10 million through preferred stock, the company would issue:

Number of Preferred Shares = $10,000,000 / $1,000 = 10,000 preferred shares

Advantages include fixed dividends and priority over common stock in dividends and liquidation, reducing risk for preferred shareholders. However, the fixed dividend obligations could strain cash flows, especially if earnings fluctuate or interests rise.

Issuing Bonds

The company can issue bonds with a par value of $1,000 each, maturing in 10 years and offering a 3.5% interest rate. Total bonds issued would need to be:

$10,000,000 / $1,000 = 10,000 bonds

Bondholders receive fixed interest payments annually, which are tax-deductible, making debt financing potentially cheaper than equity. However, increased debt elevates financial risk and could impact the company’s credit rating, especially if interest rates rise further.

Comparison and Recommendation

Analyzing the cost of capital indicates that bonds may be the least expensive option at a 3.5% interest rate, especially if interest rates remain stable or rise modestly. However, the fixed debt payments could be burdensome if cash flows are inconsistent. Equity issuance (common stock) provides flexibility without obligation but dilutes ownership. Preferred stock balances some features of debt and equity but entails dividend commitments.

Given the current valuation, cost of capital, market conditions, and the company's need for flexibility, a combination of debt and equity funding—such as issuing some bonds and some preferred stock—may be optimal. This diversified approach minimizes risk, balances cost, and limits ownership dilution.

Conclusion

While bonds present a lower cost of capital in the short term, a mixed approach leveraging both debt and preferred stock offers a strategic balance. Borrowing cautiously reduces dilution and preserves control, while issuing preferred stock can provide additional capital with manageable obligations. Assessing future growth prospects and market conditions suggests a conservative yet flexible financing strategy is most appropriate for JumpinJehosaPhats to support its expansion objectives effectively.

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