A U.S. company does business with a special purpose entity, formed to complete a one-year project. Qualitative factors are inconclusive regarding whether the SPE is a variable interest entity, so the company asks you to do a quantitative analysis. Here is information on expected cash flows for the SPE at the end of one year:
$$\begin{array} { | c | c | }
\hline \text { Expected Cash Flows } & \text { Probability } \
\hline \$ 3,000,000 & 0.70 \
\hline 1,200,000 & 0.20 \
\hline 600,000 & 0.10 \
\hline
\end{array}$$ The SPE was formed with an investment of $2,000,000, financed with $1,750,000 in debt and $250,000 in equity. A discount rate of 20% is appropriate, given the project's risk.
Required a. Is this SPE a variable interest entity, based on your quantitative analysis? Show calculations clearly and explain your answer.
b. How could management manipulate the numbers to change the answer to Part a.?
c. If the answer to Part a. is "yes," how should the company decide if it should consolidate the SPE?
d. If the answer to Part a. is "no," how should the company decide if it should consolidate the SPE?

Question

A U.S. company does business with a special purpose entity, formed to complete a one-year project. Qualitative factors are inconclusive regarding whether the SPE is a variable interest entity, so the company asks you to do a quantitative analysis. Here is information on expected cash flows for the SPE at the end of one year:
 $$\begin{array} { | c | c | } 
\hline \text { Expected Cash Flows } & \text { Probability } \
\hline \$ 3,000,000 & 0.70 \
\hline 1,200,000 & 0.20 \
\hline 600,000 & 0.10 \
\hline
\end{array}$$ The SPE was formed with an investment of $2,000,000, financed with $1,750,000 in debt and $250,000 in equity. A discount rate of 20% is appropriate, given the project's risk.
Required a. Is this SPE a variable interest entity, based on your quantitative analysis? Show calculations clearly and explain your answer.
b. How could management manipulate the numbers to change the answer to Part a.?
c. If the answer to Part a. is "yes," how should the company decide if it should consolidate the SPE?
d. If the answer to Part a. is "no," how should the company decide if it should consolidate the SPE?

Quizplus · Accepted Answer

The Answer of A U.S. company does business with a special purpose entity, formed to complete a one-year project. Qualitative factors are inconclusive regarding whether the SPE is a variable interest entity, so the company asks you to do a quantitative analysis. Here is information on expected cash flows for the SPE at the end of one year:
 $$\begin{array} { | c | c | } 
\hline \text { Expected Cash Flows } & \text { Probability } \
\hline \$ 3,000,000 & 0.70 \
\hline 1,200,000 & 0.20 \
\hline 600,000 & 0.10 \
\hline
\end{array}$$ The SPE was formed with an investment of $2,000,000, financed with $1,750,000 in debt and $250,000 in equity. A discount rate of 20% is appropriate, given the project's risk.
Required a. Is this SPE a variable interest entity, based on your quantitative analysis? Show calculations clearly and explain your answer.
b. How could management manipulate the numbers to change the answer to Part a.?
c. If the answer to Part a. is "yes," how should the company decide if it should consolidate the SPE?
d. If the answer to Part a. is "no," how should the company decide if it should consolidate the SPE?

A US Company Does Business with a Special Purpose Entity, Formed