Juan Ramirez and Jimmy Smith are considering forming a partnership to engage in the business of aerial photography. Ramirez is a licensed pilot, is currently earning $48,000 a year, and has $50,000 to invest in the partnership. Smith is a professional photographer who is currently earning $30,000 a year. He has recently inherited $70,000, which he plans to invest in the partnership.

Both partners will work full-time in the business. After careful study, they have estimated that expenses are likely to exceed revenue by $10,000 during the first year of operations. In the second year, however, they expect the business to become profitable, with revenue exceeding expenses by an estimated $90,000. (Bear in mind that these estimates of expenses do not include any salaries or interest to the partners.) Under present market conditions, a fair rate of return on capital invested in this type of business is 20 percent.

Instructions

a. On the basis of this information, prepare a brief description of the income-sharing agreement that you would recommend for Ramirez and Smith. Explain the basis for your proposal.

b. Prepare a separate schedule for each of the next two years showing how the estimated amounts of net income would be divided between the two partners under your plan. (Assume that the original capital balances for both partners remain unchanged during the two-year period. This simplifying assumption allows you to ignore the changes that would normally occur in capital accounts as a result of divisions of profits, or from drawings or additional investments.)

c. Write a brief statement explaining the differences in allocation of income to the two partners and defending the results indicated by your income-sharing proposal.