Twin Peaks, a power company, seeks to acquire an electric generating plant for $400 million to expand its market share. It expects to sell the electricity generated by the plant acquisition at a profit to its owners. Twin Peaks’s general credit rating allowed for a 4 percent annual interest rate on a debt issue. It explored establishing a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks.

The separate entity will isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral. An interest rate of 3 percent on the debt is available, producing before-tax savings of $4 million per year.

To obtain the lower interest rate, however, Twin Peaks must: Guarantee the separate entity’s debt. Maintain its own predefined financial ratios and restrict the amount of additional debt it can assume.

Twin Peaks establishes Power Finance Co., designed solely to own, finance, and lease the electric generating plant to Twin Peaks. The documents governing the new entity specify the following:

• The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks.
• An outside investor will provide $16 million in exchange for a 100 percent nonvoting equity interest in Power Finance.
• Power Finance will issue debt in exchange for $384 million. Twin Peaks guarantees the debt because the $16 million equity investment is insufficient to attract low-interest debt financing.
• Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of $12 million per year based on a 3 percent fixed interest rate for the debt and equity investors for an initial five-year lease term.

At the end of the five-year lease term (or any extension), Twin Peaks must do one of the following:

• Renew the lease for five years subject to the approval of the equity investor.
• Purchase the electric generating plant for $400 million.
• Sell the electric generating plant to an independent third party. If the proceeds of the sale are insufficient to repay the equity investor, Twin Peaks must make a payment of $16 million to the equity investor.

1. Does Power Finance have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support?

Multiple Choice

• Yes because its owners’ equity is greater than 10% of the total assets.

• Yes because Twin Peak guarantees Power Finance’s debt.

• No because Power Finance will issue $384 million debt.

• No because its owners’ equity is less than 10% of the total assets AND Twin Peak guarantees Power Finance’s debt.