Nick Sullivan and Donna James have written a computer program for a virtual reality video game system; it is expected to be more popular than any other gaming system currently on the market. They need additional capital to market the product, and they plan to incorporate their business. Sullivan and James are considering alternative capital structures for the corporation. Their primary goal is to raise as much capital as possible without giving up control of the business. Sullivan and James plan to receive 50,000 shares of the corporation’s common stock in return for the net assets of their old business. After the old company’s books are closed and the assets are adjusted to current market value, Sullivan’s and James’s capital balances will each be $25,000. The corporation’s plans for a charter include an authorization to issue 10,000 shares of preferred stock and 500,000 shares of $1 par common stock. Sullivan and James are uncertain about the most desirable features for the preferred stock. Prior to incorporating, they are discussing their plans with two investment groups. The corporation can obtain capital from outside investors under either of the following plans:

■ Plan 1. Group 1 will invest $80,000 to acquire 800 shares of 6%, $100 par, nonvoting, preferred stock.

■ Plan 2. Group 2 will invest $55,000 to acquire 500 shares of $5, no-par preferred stock and $35,000 to acquire 35,000 shares of common stock. Each preferred share receives 50 votes on matters that come before the stockholders.

Requirements

Assume that the corporation is chartered.

1. Journalize the issuance of common stock to Sullivan and James. Debit each person’s capital account for its balance.

2. Journalize the issuance of stock to the outside investors under both plans.

3. Assume that the company’s net income for the first year is $120,000 and total dividends are $30,000. Prepare the stockholders’ equity section of the corporation’s balance sheet under both plans.

4. Recommend one of the plans to Sullivan and James. Give your reasons. (Challenge)