(Off-Balance-Sheet Financing) Brad Pitt Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. 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 Pitt, Aidan Quinn, approached the president of the Aluminum Can Company (ACC), their 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 their own can production. The Aluminum Can Company 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 Pitt’s land adjacent to the existing plant. Second, Pitt would sign a 20-year purchase agreement. Under the purchase agreement, Pitt 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 Pitt 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, Pitt 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 Pitt.

Instructions

(a) What are project financing arrangements using special purpose entities?

(b) What are take-or-pay contracts?

(c) Should Pitt record the plant as an asset together with the related obligation?

(d) If not, should Pitt record an asset relating to the future commitment?

(e) What is meant by off-balance-sheet financing?