Pitt Corporation is interested in building a pop can manufacturing plant next to its existing plant in Montreal. 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 about the cash flow problems of making payments; instead, its real concern is the impact of adding long-term debt to its balance sheet.
The president of Pitt, Aidan O’Reilly, approached the president of Aluminum Can Corp. (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 Pitt would begin its own can production. ACC could not afford to lose the account.
After some discussion, a two-part plan was worked out. First ACC will construct a plant on Pitt’s land next to the existing plant, and the plant will initially belong to ACC. Second, Pitt will sign a 20-year purchase agreement. Under the purchase agreement, Pitt will express its intention to buy all of its cans from ACC and pay a unit price that at normal capacity would cover labour and material, an operating management fee, and the debt service requirements on the new plant. The expected unit price, if transportation costs are taken into consideration, is lower than the current market price. If Pitt ends up not taking enough production in any specific year and if the excess cans cannot be sold at a high enough price on the open market, Pitt agrees to make up any cash shortage so that ACC can make the payments on its debt. The bank is 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 will become Pitt’s.
Instructions
Adopt the role of the controller and discuss the financial reporting issues. The company is a private company. (Hint: Use first principles.)