Question

Joe and Doug Entity jointly started a business that required net operating assets of $1,000, consisting of $1,100 total assets (plant and equipment, inventory, accounts receivable, etc.) less $100 of non-interest bearing liabilities (accounts payable, wages payable, taxes payable, etc.). The $1,000 net investment required to finance the business consisted of $300 invested in common stock by the more adventurous brother, Joe, and $700 loaned to the business by the more conservative brother, Doug, where the interest rate on the loan was 10%. Assume there are no taxes on this business so there is no tax expense.

These facts resulted in the following condensed balance sheet and income statement:

Assets (various)                         1,100            Non-interest bearing liabilities           100

                                                                        Debt (10% interest rate)                      700

                                                                        Common Stock                                   300

    Total Assets                           1,100               Total Liabilities and Equities       1,100

Operating Income (Revenue less all operating expenses)      150

Interest Expense (10% x $700)                                                 70

Net Income                                                                               80

1. From the point of view of Joe, the equity investor for the firm, what is income to Joe and what is the amount Joe invested? (This is the proprietary perspective on performance, i.e., performance from the point of view of the equity investor.)

2.   From the point of view of Joe and Doug, who constitute all of the investors in the firm (both equity and debt), what is combined income (income to Joe and income to Doug combined) and what is the amount invested (by Joe and by Doug combined)? (This is the entity perspective on performance, i.e., performance from the point of view of the equity and debt investors combined.)

3.   When the company was founded, Joe and Doug discussed two alternative capital structures that could have provided the required $1,000 total investment:
i) $100 of common stock purchased by Joe and a $900 loan from Doug,
ii) $600 of common stock purchased by Joe and a $400 loan from Doug. Assuming for the sake of simplicity that the interest rate on the loan from Doug would still have been 10% for either of these alternative capital structures,

a)   recalculate net income for each of the two alternative cost structures and then evaluate results for the year from the proprietary perspective for each of the two alternative cost structures.

b)   Evaluate results for the year from the entity perspective for each of the two alternative cost structures.

Answer 1

for computation of net income for Joe interest expenses not taken because he is invested stock for this no interest.

computation of income for Mr. Joe:
Investment ratio for Joe		$		3
Total income for existing option		150		Joe
$				45
Interest exp not taken $		70
Net income $				45

for second case

computation of income for Mr. Joe:
Investment ratio for Joe and Doug		$		3	7
Total income for existing option		150		Joe	Doug
				45	105
Less interest expense		70		21	49
Net income				66	154

Computation of Net income for alternate options
Investment ratio for Joe and Doug option 1				1	9
Total income				Joe	Doug
		150		15	135
Less interest expense		-90		-9	-81
Net income		80		6	54
Investment ratio for Joe and Doug option 2				6	4
Total income				Joe	Doug
		150		90	60
Less interest expense		-40		-24	-16
Net income		110		66	44

for entity purpose the second option is better net income was more.