Twin peaks will lease the electric generating plant


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 both the debt
and equity investors for an initial lease term of five years.

At the end of the 5-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.

Once the purchase of the electric generating plant is complete and the equity and debt are issued,
Power Finance Company reports the following balance sheet:
POWER FINANCE COMPANY
Balance Sheet
January 1, 2017
Electric Generating Plant $400M Long-Term Debt $384M
Owners’ Equity 16M
Total Assets
$
400M Total Liabilities and OE $400M
Exhibit 6.2 shows the relationships between Twin Peaks, Power Finance, the electric generating
plant, and the parties financing the asset purchase.
EXHIBIT 6.2 Variable Interest Entity to Facilitate Financing
In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Company,
two conditions must be met. First, Power Finance must qualify as a VIE by either (1) an inability
to secure financing without additional subordinated support or (2) a lack of either the risk of
losses or entitlement to residual returns (or both). Second, Twin Peaks must qualify as the
primary beneficiary of Power Finance.
In assessing the first condition, several factors point to VIE status for Power Finance. Its owners’
equity comprises only 4 percent of total assets, far short of the 10 percent benchmark. Moreover,
Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its
operations without additional support. Finally, the equity investor appears to bear Page

267almost no risk with respect to the operations of the Ace electric plant. These characteristics
indicate that Power Finance qualifies as a VIE.
In evaluating the second condition for consolidation, an assessment is made to determine
whether Twin Peaks qualifies as Power Finance’s primary beneficiary. Clearly, Twin Peaks has
the power to direct Power Finance’s activities. But to qualify for consolidation, Twin Peaks must
also have the obligation to absorb losses or the right to receive returns from Power Finance—
either of which could potentially be significant to Power Finance. But what possible losses or
returns would accrue to Twin Peaks? What are Twin Peaks’s variable interests that rise and fall
with the fortunes of Power Finance?
As stated in the VIE agreement, Twin Peaks will pay a fixed fee to lease the electric generating
plant. It will then operate the plant and sell the electric power in its markets. If the business plan
is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s
equity investors receive the fixed fee. On the other hand, if prices for electricity fall, Twin Peaks
may generate revenues insufficient to cover its lease payments while Power Finance’s equity
investors are protected from this risk. Moreover, if the plant’s fair value increases significantly,
Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or