1. Discuss the arguments for and against classifying the issuance of the $25 million of stock as debt.
2. What do you think might be a practical solution to this classification problem?
Sahara Unlimited Inc. began operations on January 2, 20Y4, with the issuance of 250,000 shares of $8 par common stock. The sole stockholders of Sahara Unlimited Inc. are Karina Takemoto and Dr. Noah Grove, who organized Sahara Unlimited Inc. with the objective of developing a new flu vaccine. Dr. Grove claims that the flu vaccine, which is nearing the final development stage, will protect individuals against 80% of the flu types that have been medically identified. To complete the project, Sahara Unlimited Inc. needs $25,000,000 of additional funds. The banks have been unwilling to loan the funds because of the lack of sufficient collateral and the riskiness of the business. The following is a conversation between Karina Takemoto, the chief executive officer of Sahara Unlimited Inc., and Dr. Noah Grove, the leading researcher:
Karina: What are we going to do? The banks won't loan us any more money, and we've got to have $25 million to complete the project. We are so close! It would be a disaster to quit now. The only thing I can think of is to issue additional stock. Do you have any suggestions?
Noah: I guess you're right. But if the banks won't loan us any more money, how do you think we can find any investors to buy stock?
Karina: I've been thinking about that. What if we promise the investors that we will pay them 2% of sales until they have received an amount equal to what they paid for the stock?
Noah: What happens when we pay back the $25 million? Do the investors get to keep the stock? If they do, it'll dilute our ownership.
Karina: How about, if after we pay back the $25 million, we make them turn in their stock for what they paid for it? Plus, we could pay them an additional $50 per share. That's a $50 profit per share for the investors.