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 Peakss 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 Peakss 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 entitys 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.

Does Twin Peaks have the obligation to absorb losses or the right to receive returns from Power Finance?

Multiple Choice

• Yes because Twin Peak is protected from risk of loss when electricity prices fall.

• Yes because Twin Peaks will enjoy residual profits from operating while Power Finances equity investors receive the fixed fee.

• No because Power Finances equity investors receive the fixed fee.

• No because Twin Peaks will pay a fixed fee to lease the electric generating plant, operate the plant, and sell the electric power in its markets.

2

Who is the primary beneficiary of Power Finance?

Multiple Choice

• Outside Investor that invests 16 million.

• The bank that holds $384 million debt.

• Twin Peak.

• No one.