$$ Case $9-3$

P Co$.$ is looking for some additional financing in order to renovate one of the company$$s manufacturing plants. It is having difficulty getting new debt financing because its debt$-$to$-$equity ratio is higher than the $3$:$1$ limit stated in its bank covenant. It is unable to attract an equity partner because the sole owner of P Co$.$ has set equity partner conditions that make it practically impossible to find a new equity investor.

Part of the problem results from the use of historical cost accounting. If the company$$s assets were recorded at fair value, the debt$-$to$-$equity ratio would be much lower. In order to get around the requirements for historical cost accounting, Jamal Irving, the CFO for P Co$.,$ came up with the following plan.

On July $2,$ Year $5,$ P Co$.$ will sell its manufacturing facility to SPE at its fair value of $$1,600,000$ in the form of a non$$interest$-$bearing note receivable. SPE will be set up for the sole purpose of renovating the manufacturing facility. No other activities may be carried out by SPE without the approval of P Co$.$ Mr$.$ Renovator, an unrelated party, will invest $$700,000$ in cash as the sole owner of SPE. SPE will borrow $$300,000$ to provide additional funds to cover the $$1,000,000$ estimated cost of the renovation, which is expected to take $6$ months. P Co$.$ will guarantee the amount borrowed by SPE.

On January $1,$ Year $6,$ after the renovation is complete and one day after P Co$.$s year$-$end, SPE will sell the manufacturing facility back to P Co$.$ at $$2,740,000$ and will be wound up$.$ P Co$.$ will finance the repurchase with a $$1,090,000$ bank loan, offsetting the $$1,600,000$ note receivable from SPE and $$50,000$ in cash. By selling the unrenovated facility and repurchasing the renovated facility, P Co$.$ hopes to reflect the facility at its fair value, borrow the money to finance the renovation, and improve its debt$-$to$-$equity position.

$$ The existing and pro forma balance sheets $($in $000$s$)$ and debt$-$to$-$equity ratios for P Co$.$ and SPE as prepared by the CFO at P Co$.$ are presented below in condensed form:

Actual P Co$.$ June $30/5$Pro Forma P Co$.$ Dec. $31/5$Pro Forma P Co$.$ Jan. $1/6$Pro Forma SPE Dec. $31/5$Note receivable from SPE$$250$$$1,600$$$2,740$$$2,600$Manufacturing facility$2,07502,0250$Other assets$2,3253,6754,7652,600$Note payable to P Co$\mathrm{.}1,600$Income tax payable$$405$$$405$Other liabilities$1,8501,8502,940300$Common shares$303030700$Retained earnings$4451,3901,390$Debt$-$to$-$equity ratio$3\mathrm{.}89$:$11\mathrm{.}59$:$12\mathrm{.}36$:$12\mathrm{.}71$:$1$