Question 1. SERVER BUILDING COMPANY
Jeff Warren just graduated from UC with a master’s degree in Information Technology. He wants to set up his own server building company to help make networking of businesses run smoothly in his municipality. The servers will play a key role in telephony, internet and intranet connections in corporate organizations and other institutions in the Hilton area. He knows from independent investment research that IT business is striving and very profitable in the State of South Carolina where he wants to locate the business.
Jeff knows that before he can invest his time and other resources in the project, he must obtain financing, which means that he must raise money to pay for the investment cost and other operating expenses. Because his company is not going to be listed in any stock exchange market, he can’t raise equity funding publicly. Therefore, he has decided to raise $800,000 long-term debt from Key Finance Company. The loan must be repaid in 10 years at 5.8% interest rate per year.
Jeff learnt in corporate finance course he took two years ago the advantages and disadvantages of different forms of business organizations (mainly sole proprietorship, partnership and corporation). One disadvantage of sole proprietorship he can easily recall is that it has unlimited liability for business debts and obligations. No distinction is made between personal and business assets. He also remembers that a corporation has advantages of unlimited life, and that owners enjoy limited liability. He is not much concerned for now about advantages and disadvantages of business structures. However, in the future when the business grows in size and wants to change from, say, a sole proprietorship to a partnership or corporation or to some other business entity then he will look into the advantages and the disadvantages. Jeff is worried about the concept of limited liability and how it will affect his personal fortune in the future if he defaults in paying the loan.
The total value of assets in the balance sheet will be $1,100,000 and the total value of debt will be $800,000 once he starts the business. His equity in the business is $300,000. He is also thinking about forming a partnership with one of the guys he met in college. They have agreed to share profits and losses equally if they decide to form a general partnership.
Jeff has approached you to help him understand what limited liability means.
a. Explain limited liability to Jeff.
Specifically, he has asked you to help him answer the following questions.
b. Assuming the debt increased to $2 million at the end of the 10-year maturity period and the total market value of the asset of the business is $1.2 million, how much is Jeff personally responsible for if the business is established as a:
i. sole proprietorship,
ii. Partnership, or
c. Ultimately, what form of business organization would you recommend Jeff to consider. Why?
Question 2. ACCOUNTING AND CASH FLOW
Jeff is happy that once he starts the business, he would be able to generate enough profits to meet his obligations. However, he read from an article published in one of the financial journals that profit is not a good measure of a business cash flow. Jeff wants to know why the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during the period of business operations?