Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective is 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 statement of financial position.
The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement since it seemed inevitable that Ryan would begin its own can production, and ACC could not afford to lose the account.
After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement.
Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, 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 Ryan 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, Ryan agrees to make up any cash shortfall so that ACC 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 Ryan.
Instructions
a. What are project financing arrangements using special purpose entities?
b. What are take-or-pay contracts?
c. Should Ryan record the plant as an asset together with the related obligation? If not, should Ryan record an asset relating to the future commitment?
d. What is meant by off-balance-sheet financing?
