Amana Corporation is interested in building its own soda can manufacturing plant near its existing plant in Ramallah, Palestine. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet. The president of Amana approached the president of Ramallah Can Company (RCC), its major supplier, to see if some agreement could be reached. RCC was happy to work out an arrangement, since it seemed inevitable that Amana would begin its own can production. RCC could not afford to lose the account. After some discussion, a two-part plan was worked out. First, RCC was to construct the plant on Amana’s land near to the existing plant. Second, Amana would sign a 20-year purchase agreement. Under the purchase agreement, Amana would express its intention to buy all of its cans from RCC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Amana did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Amana agrees to make up any cash shortfall so that RCC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Amana. Required a) What is meant by project financing arrangements using special-purpose entities? b) Should Amana Corporation record the plant as an asset together with the related obligation? Explain briefly. c) If not, should Amana Corporation record an asset relating to the future commitment to purchase all of its cans from RCC? Explain briefly. d) What is meant by off-balance-sheet financing? Explain briefly.
Amana Corporation is interested in building its own soda can manufacturing plant near its existing plant in Ramallah, Palestine. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet. The president of Amana approached the president of Ramallah Can Company (RCC), its major supplier, to see if some agreement could be reached. RCC was happy to work out an arrangement, since it seemed inevitable that Amana would begin its own can production. RCC could not afford to lose the account.
After some discussion, a two-part plan was worked out. First, RCC was to construct the plant on Amana’s land near to the existing plant. Second, Amana would sign a 20-year purchase agreement. Under the purchase agreement, Amana would express its intention to buy all of its cans from RCC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Amana did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Amana agrees to make up any cash shortfall so that RCC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Amana.
Required
- a) What is meant by project financing arrangements using special-purpose entities?
- b) Should Amana Corporation record the plant as an asset together with the related obligation? Explain briefly.
- c) If not, should Amana Corporation record an asset relating to the future commitment to purchase all of its cans from RCC? Explain briefly.
- d) What is meant by off-balance-sheet financing? Explain briefly.
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