Question

Required 1. Prepare the journal entry to reflect the initial $100,000 investment mder 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 Adriana adopt? Explain.

Answer 1

1. Journal Entries
a) Adriana's Sister Cicely
Date	Particulars	Debit ($)	Credit ($)
	Cash	$100,000
	Common Stock		$100,000
b) Adriana's Uncle Marcello
Date	Particulars	Debit ($)	Credit ($)
	Cash	$100,000
	7% Preferred Stock		$100,000
c) Adriana's Banker
Date	Particulars	Debit ($)	Credit ($)
	Cash	$100,000
	Note Payable		$100,000
2. Evaluation of each option, with pros & cons.
a) Adriana's Sister Cicely
By allowing her sister Cicely to invest in the company, Adriana will give her partial ownership in the company. This gives her sister the legal right to vote and approve major decisions of the company, with the right to dividend.
Pros : (i) No interest expense on common stock.
(ii) Ownership stays in the family.
Cons : (i) Diluted ownership of the company
(ii) Her sister will be involved in decision making.
b) Adriana's Uncle Marcello
By allowing her uncle Marcello to invest in the company, Adriana will give her preference shareholding in the company. This gives her uncle the legal right to preferred Fixed Dividend and a higher claim on the company's assets in the event of bankruptcy and liquidation.
Pros : (i) No voting rights to the preference shareholder.
(ii) more flexible than debt when it comes to missing an annual payment.
Cons : (i) Fixed Dividend is a burden on common stockholders.
(ii) Higher cost as compared to Debt.
c) Adriana's Banker
By taking the debt option for the company, Adriana will enjoy full ownership of the company. The banker would charge interest for the use of debt finance on a monthly basis, which would be an additional expense for the company. But this would also Financial Leverage for the company.
Pros : (i) No loss of control over the company.
(ii) Tax deduction for the interest cost.
(ii) Financial Leverage if the return rate for business is more than the interest rate.
Cons : (i) Fixed payments on fixed dates, failing which would be chargeable to penalty and legal action.
(ii) The cash flow will be affected.
(ii) Additional/Collateral security might be demanded.
3. Recommendation.
Adriana should select the first option of allowing her sister Cicely to invest in the company as a common shareholder. By selecting this option Adriana would be free from any fixed dividend/interest payments as a cost and also the ownership of the company would stay in her family only. With additional growth from this incremental investment from her sister, the whole of the additional income generated would be shared in the family itself.