Download - Two Cases on Financial Assets and Liabilities Ross Jennings University of Texas at Austin
Two Cases on Financial Assets and Liabilities
Ross JenningsUniversity of Texas at Austin
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
Measurements 2
Financial Assets and Liabilities
Case 1: An equity investment in a publicly-traded stock Level of valuation inputs—1, 2, or 3?
Observable? Active market? Identical or similar asset?
Unit of Account? Bid, ask, or last-trade price?
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Financial Assets and Liabilities
Case 2: A loan to an “affiliated” company from both lender’s and borrower’s perspectives Level of valuation inputs—1, 2, or 3?
Observable? Active market? Identical or similar asset?
Present value calculations Contracted future cash flows Expected future cash flows Adjusting for risk
Gains for borrowers when credit standing falls
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Equity Investment
Case 1: The Facts On October 10, 2008, in a negotiated transaction
with a third party, Sprint Nextel (SN) bought 2 million shares of Delphi Wireless for $12 per share plus $1.1 million in fees
That day, 100K shares of Delphi traded on the exchange, the final trade was at $12.50 and the closing bid and ask were $12.50 and $12.65, respectively
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Equity Investment
Case 1: The Facts During the 4th quarter of 2008
Delphi trading volume averaged 200K shares/day 15 of 51 trading days had no volume The day of the 3rd qtr earnings announcement
5 million shares traded on strong earnings news For the quarter, high price was $14.30 and low was
$9.25
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Equity Investment
Case 1: The Facts On December 31, 2008
The last trade of Delphi stock occurred three hours before the exchange closed
That trade was 1,000 shares for $13.80 The closing bid and ask were $13.65 and $13.90,
respectively
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Equity Investment
Case 1: Required: The journal entry for acquisition of Delphi stock Fair value of investment on 12/31/08, following
SFAS 157 Is this investment level 1, 2, or 3? Journal entry on 12/31/08 if “available-for-sale” Journal entry on 12/31/08 if “trading”
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Equity Investment
Case 1: The Issues Unit of Account
Block of shares? Single share?
Level of valuation inputs (1, 2, 3?) Active market for identical assets (ongoing pricing info)? Ability to access?
Choice of market value Last trade? Closing bid? Closing ask?
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Equity Investment
Case 1: Solution Single share is unit of account (para 27) Level 1 asset Use closing bid price (para 31)
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Equity Investment
Case 1: Solution
Quarter High 14.30 Closing Ask 13.90 Last Trade 13.80 Closing Bid 13.65 Purchase Day Closing Ask 12.65 Purchase Day Closing Bid 12.50 Purchase Day Last Trade 12.50 Purchase Price 12.00 Quarter Low 9.25 Purchase Day
Holding Gain
Quarter End Holding Gain
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-A
Case 2(A): The Facts SN loans $10 million to East Idaho Communications (EIC)
on 1/1/08 at 8 percent compounded annually, with repayment as $4 million on 12/31/08 $4 million on 12/31/09 Outstanding balance on 12/31/10
8% interest rate is based on yields of publicly-traded debt for companies with similar credit standing
No changes in interest rates or credit standing during first three quarters of 2008
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Loan Agreement-A
Case 2(A): Required As of 9/30/08, what was the fair value for SN of
this loan receivable As of 9/30/08, was this a level 1, 2, or 3 asset
under SFAS 157?
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Loan Agreement-A
Case 2(A): The Issues Accruing interest at contracted rate Level of valuation inputs (1, 2, 3?)
Active market? Identical or similar asset?
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-A
Case 2(A): Solution Fair value
= 10 + (10)(0.08)(9/12) = $10.6 million
Valuation input is the interest rate of 8 percent, which is an observable rate from an active market for similar loans, therefore this is a level 2 asset
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Loan Agreement-B
Case 2(B): The Facts During the fourth quarter of 2008 EIC’s credit
standing deteriorates SN agrees to continue to accrue interest at 8
percent compounded annually, but to delay all payments by one year, which will now be $4 million on 12/31/09 $4 million on 12/31/10 Outstanding balance on 12/31/11
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-B
Case 2(B): The Facts SN views the market interest rate for this loan as
now higher than 8% and more than 9.5%, the highest observable rate for the worst rated publicly-traded debt
One manager argues that SN would be indifferent to continuing with the loan or just getting their $10 million back (sacrificing the interest for 2008)
Risk-free rate is 4 percent Probability of default equals 7 percent
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-B
Case 2(B): Required As of 12/31/08, what are the amounts and timing of the
contracted cash flows? What interest rate for these cash flows is implied by the
“subjective” valuation of $10 million? As of 12/31/08, what are the amounts and timing of the
expected cash flows? What interest rate for these cash flows is implied by the
“subjective” valuation of $10 million? Explain the difference in these two interest rates As of 12/31/08, what level is the fair value of this asset
under SFAS 157, 1, 2, or 3?
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Loan Agreement-B
Case 2(B): The Issues Difference between “contracted” cash flows and
“expected” cash flows Discounting “contracted” cash flows versus
discounting “expected” cash flows Level of valuation inputs (1, 2, 3?)
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Loan Agreement-B
Case 2(B): Solution Contracted cash flows
$4 million on 12/31/09 $4 million on 12/31/10 $4.619 million on 12/31/11
Solve for r where 10 = 4/(1+r)1 + 4/(1+r)2 + 4.619/(1+r)3
r = 12.27%
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-B
Case 2(B): Solution Expected cash flows
$4(0.93) = $3.72 on 12/31/09 $4(0.93) = $3.72 on 12/31/10 $4.619(0.93) = $4.296 on 12/31/11
Solve for r where 10 = 3.72/(1+r)1 + 3.72/(1+r)2 + 4.296/(1+r)3
r = 8.24%
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-B
Case 2(B): Solution
12/08 12/09 12/10 12/11
Contracted CF 4.00 4.00 4.619PV = 10 if r = 12.27%
Expected CF 3.72 3.72 4.296PV = 10 if r = 8.24%
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Loan Agreement-B
Case 2(B): Solution Compensation for
Default Risk of default
are not the same thing Would SN be indifferent between
$93 for certain 93% probability of $100 and 7% probability of $0
The answer is no, they want compensation for the second over the first
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Loan Agreement-B
Case 2(B): Solution The first discount rate “strips out”
Compensation for the time value of money (including inflation)
Compensation for riskiness (uncertainty) of expected future cash flows
Compensation for probability of default The second discount rate “strips out” only
the first two (the CF themselves adjust for the third)
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Loan Agreement-B
Case 2(B): Solution There are no observable valuation inputs
for this asset, all inputs are judgments made by SN managers—this is a level 3 asset
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Loan Agreement-C
Case 2(C): The Facts EIC has discussed the possibility of borrowing
with several banks EIC believes they could borrow 50 cents on the
dollar of assets used as collateral at an interest rate of 14%
EIC has signed no contracts with any of these banks
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Loan Agreement-C
Case 2(C): Required Following SFAS 157 is 14% an appropriate rate
for EIC to use to value their loan to SN? What journal entries would EIC record on
12/31/08 if they use 14% to value this loan? As of 12/31/08, what level is the fair value of this
liability under SFAS 157, 1, 2, or 3?
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Loan Agreement-C
Case 2(C): The Issues Level of valuation inputs (1, 2, 3?)
When is an interest rate (valuation input) “observable”? When is an interest rate (valuation input) “comparable”?
Should borrowers record gains in income when their credit standing deteriorates?
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Loan Agreement-C
Case 2(C): Solution 14% is not an appropriate interest rate because it
is for a loan secured by assets twice the value of the loan balance, not an unsecured loan like the one from SN
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Loan Agreement-C
Case 2(C): Solution If they value the loan using 14%, they should
accrue interest expense at 8% for the fourth quarter
(10)(0.08) = $200K
and then record a gain for the decrease in the fair value from changing discount rates from 8% to 14% = 10,800 – 9,705 = $1,095
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-C
Case 2(C): Solution The “quoted” rate from the banks is not
“observable” in an active market, and also is not for an identical loan because it is for a collateralized loan, not an unsecured loan—this is a level 3 liability
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Loan Agreement-D
Case 2(D): The Facts EIC made the first required payment (under the
renegotiated terms) on 12/31/09 SN believes that EIC’s credit standing has
improved to be the same as that of the highest rated below-investment-grade debt
This rating has an observable market-based yield of 9.5%
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Loan Agreement-D
Case 2(D): Required Calculate the total effect on SN’s 2009 net income
of their loan to EIC Divide the total income for 2009 into interest
income and holding gains/losses under each of the following alternatives No interest income, all holding gains/losses Interest income determined using discount rate implicit
in fair value as of 12/31/08 (beg of period) Interest income determined using original interest rate
(8%)
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Loan Agreement-D
Case 2(D): The Issues Dividing income into interest income and holding
gains and losses
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Loan Agreement-D
Case 2(D): Solution Beginning value for 2009 is $10 million
Ending value for 2009 is $4 million of cash plus loan receivable asset of $7,506K (PV of contracted FCF discounted at 9.5%), for a total of $11,506
Change equals income of $11,506 – $10,000 = $1,506
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Loan Agreement-D
$10M
12/08
12/08
12/09
Inc = 1,506K
Total income, made up of (a) accrued interest revenue and (b) holding gain from improved credit standing
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Loan Agreement-D
$10M
12/08
12/08
12/09
HG = 1,506K
Int = 0
All income assigned to holding gain from improved credit standing
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Loan Agreement-D
$10M
12/08
12/08
12/09
HG = 279K
Int = 1,227K
Interest revenue accrued at 12.27% for year, then holding gain at end of year from improved credit standing
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-D
$10M
12/08
12/08
12/09
HG = 642K
Int = 864K
Interest revenue accrued at original rate of 8% on original balance of $10,800, then holding gain brings to fair value
AAA - 2008 - AnaheimTeaching Fair ValueConcepts and
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Loan Agreement-D
Case 2(D): Solution Division into interest and holding G/L
Int = 0, HG = $1,506
Int = $1,227K (10 million x 12.27%), HG = 1,506K – 1,227K = $279K
Int = $864K (10.8 million x 8%),HG = 1,506K – 864K = $642K
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Summary
Level 1, 2, or 3 inputs based on observable market inputs for identical or comparable assets and liabilities
Unit of account for equity investments (can be important in other fair values)
Present value computations for contracted cash flows or expected cash flows with appropriate discounting for risk
Dividing income into interest income/expense and holding gains and losses
Borrowers recording gains when their credit standing deteriorates