Off balance sheet financing. Assume that International Paper Company (IP) wishes to obtain $75 million of additional financing without recording additional debt on its balance sheet. To do this, it creates a trust to which, on January 1, it transfers cutting rights to a mature timber tract. The trust will pay for these rights by borrowing $75 million for five years from a bank, with interest at 8%. The trust promises to make five equal installment payments, one on December 31 of each year. The trust will harvest and sell timber each year to obtain cash to make the loan payments and to pay operating costs. At current prices, the value of the standing wood exceeds by 10% the amounts the trust will need to service the loan and to pay ongoing operating costs (including wind, fire, and erosion insurance). The future selling price of timber will determine the trust’s actions, as follows: If the selling price of timber declines, the trust will harvest more timber and sell it to service the debt and to pay operating costs. If the selling price of timber increases, the trust will harvest timber at the level originally planned and invest cash receipts that exceed debt service and operating costs to provide a cushion for possible future price decreases. At the end of five years, the trust will distribute the value of any cash and uncut timber to IP. IP will guarantee the debt in the event cash flows from selling the timber are inadequate to pay operating costs and service the debt. The bank has the right to inspect the tract at any time and to replace IP’s forest management personnel with managers of its own choosing if it feels that IP is mismanaging the tract.
a. Identify IP’s economic returns and risks in this arrangement.
b. Identify the bank (lender’s) economic returns and risks in this arrangement.
c. Should IP treat this transaction as a loan (a liability will appear on IP’s balance sheet) or as a sale (no liability will appear on IP’s balance sheet)? Explain your reasoning.