Lesson 4-In Class Exercise
Widgets-R-Us is a local manufacturer.  It has 5 shareholders who have each invested $200 and together own all 1,000 shares of the stock of the corporation.  There is no other stock or debt outstanding.  

Due to the increase in demand for widgets, the owners of the local corporation decide they need to increase capacity.  An additional $5,000 in cash will be needed to purchase 5 additional widget making machines.  Here are some financing alternatives:

For each alternative below:

a)	List the factors that might be considered in determining whether the financing instruments listed below are more like debt or equity.  

b)  Advise the shareholders of your best guess as to how, on balance, each instrument would be likely to be viewed by the IRS.

i.	The corporation would issue notes to the public to raise cash to purchase new machines.  Each note would have a face amount of $100, with interest payable annually at market rates.  According to the terms of the notes, if the corporation’s cash flow is weak (defined by a formula in the agreement), it may skip the interest payments, but they will accumulate and come due at the maturity of the notes.  Missed interest payments will themselves accumulate interest at market rates.  In addition, the corporation may defer repayment of the principal for up to ten years beyond the initial maturity date if its cash flow is weak.

ii.	Two of the shareholders would loan the corporation $2,500 which they would obtain from a line of credit each has at local bank.  The shareholders would receive a written note from the corporation for $2,500 providing for a variable rate of interest, 3% higher than the rate they pay on the line of credit.  The interest rate is adjustable and interest payments (both to the shareholders and on the LOC ) are to be made annually.  The loans are to be repaid to the shareholders in 5 years.