(1) The First National Bank Sells automobile loans to a separate entity known as
ID: 2726953 • Letter: #
Question
(1) The First National Bank Sells automobile loans to a separate entity known as Auto Finance Partners (AFP). AFP is financed with 89% debt and 11% equity issued to an independent investor. First National Bank’s risk is virtually nonexistent.
Triple A Company wants to build a new manufacturing plant and creates a separate entity known as Property Finance Incorporated (PFI). PFI borrows 90% of the construction cost. In order to entice the construction lender to fund the project, Triple A had to agree to pledge its common stock as additional collateral.
Are AFP and PFI considered variable interest entities?
(2) Assuming a company issues new equity to acquire a target company and the two market value of the target’s assets is greater than the book value, which of the two methods, purchase and pooling, will likely produce the higher balance for total assets?
Explanation / Answer
What is a 'Variable Interest Entity - VIE'
A variable interest entity (VIE) is an entity (investee) in which the investor has obtained less than a majority-owned interest, according to the United States Financial Accounting Standards Board. A variable interest entity (VIE) is subject to consolidation if certain conditions exist.
If a firm is the primary beneficiary of a VIE, the holdings must be disclosed on the balance sheet. The primary beneficiary is defined as the person or company with the majority of variable interests.
VIEs are commonly used within financial firms for their subprime mortgage-backed securities. They can be a special-purpose vehicle (SPV) that allows firms to keep assets off of their balance sheets. A VIE refers to the way a firm's exposure to the SPV can change. This is the key to whether or not it can be excluded from the balance sheet A corporation can use such a vehicle to finance an investment without putting the entire firm at risk. The problem, as with SPVs in the past, is that they have become a method of hiding things (such as subprime exposure).
We investigate "rms' choices between the purchase and pooling methods in stock-forstock
acquisitions. We "nd that in acquisitions with large step-ups to targets' net assets,
CEOs with earnings-based compensation are more likely to choose pooling and avoid
the earnings &penalty' associated with purchases. We "nd no association between stockbased
compensation and the purchase}pooling choice, suggesting that managers are not
concerned about implications of large step-ups for "rms' equity values. We also "nd that
the likelihood of purchase increases with debt contracting costs, consistent with its
favorable balance sheet e!ects, and with costs of qualifying for pooling, particularly the
restriction of share repurchases.
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