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Two Cases on Financial Assets and Liabilities

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Presentation on theme: "Two Cases on Financial Assets and Liabilities"— Presentation transcript:

1 Two Cases on Financial Assets and Liabilities
AAA Anaheim Two Cases on Financial Assets and Liabilities Ross Jennings University of Texas at Austin Teaching Fair Value Concepts 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 Anaheim Teaching Fair ValueConcepts and Measurements

3 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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

4 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

5 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

6 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

7 Teaching Fair ValueConcepts and Measurements
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” AAA Anaheim Teaching Fair ValueConcepts and Measurements

8 Teaching Fair ValueConcepts and Measurements
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? AAA Anaheim Teaching Fair ValueConcepts and Measurements

9 Teaching Fair ValueConcepts and Measurements
Equity Investment Case 1: Solution Single share is unit of account (para 27) Level 1 asset Use closing bid price (para 31) AAA Anaheim Teaching Fair ValueConcepts and Measurements

10 Teaching Fair ValueConcepts and Measurements
Equity Investment Case 1: Solution Quarter High Closing Ask Last Trade Closing Bid Purchase Day Closing Ask Purchase Day Closing Bid Purchase Day Last Trade Purchase Price Quarter Low 9.25 Quarter End Holding Gain Purchase Day Holding Gain AAA Anaheim Teaching Fair ValueConcepts and Measurements

11 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

12 Teaching Fair ValueConcepts and Measurements
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? AAA Anaheim Teaching Fair ValueConcepts and Measurements

13 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

14 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

15 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

16 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

17 Teaching Fair ValueConcepts and Measurements
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? 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? AAA Anaheim Teaching Fair ValueConcepts and Measurements

18 Teaching Fair ValueConcepts and Measurements
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?) AAA Anaheim Teaching Fair ValueConcepts and Measurements

19 Teaching Fair ValueConcepts and Measurements
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) /(1+r)3 r = 12.27% AAA Anaheim Teaching Fair ValueConcepts and Measurements

20 Teaching Fair ValueConcepts and Measurements
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+r) /(1+r)3 r = 8.24% AAA Anaheim Teaching Fair ValueConcepts and Measurements

21 Teaching Fair ValueConcepts and Measurements
Loan Agreement-B Case 2(B): Solution 12/08 12/09 12/10 12/11 Contracted CF PV = 10 if r = 12.27% Expected CF PV = 10 if r = 8.24% AAA Anaheim Teaching Fair ValueConcepts and Measurements

22 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

23 Teaching Fair ValueConcepts and Measurements
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) AAA Anaheim Teaching Fair ValueConcepts and Measurements

24 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

25 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

26 Teaching Fair ValueConcepts and Measurements
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? AAA Anaheim Teaching Fair ValueConcepts and Measurements

27 Teaching Fair ValueConcepts and Measurements
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? AAA Anaheim Teaching Fair ValueConcepts and Measurements

28 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

29 Teaching Fair ValueConcepts and Measurements
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 Anaheim Teaching Fair ValueConcepts and Measurements

30 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

31 Teaching Fair ValueConcepts and Measurements
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% AAA Anaheim Teaching Fair ValueConcepts and Measurements

32 Teaching Fair ValueConcepts and Measurements
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%) AAA Anaheim Teaching Fair ValueConcepts and Measurements

33 Teaching Fair ValueConcepts and Measurements
Loan Agreement-D Case 2(D): The Issues Dividing income into interest income and holding gains and losses AAA Anaheim Teaching Fair ValueConcepts and Measurements

34 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

35 Teaching Fair ValueConcepts and Measurements
Loan Agreement-D 12/08 Inc = 1,506K $10M Total income, made up of (a) accrued interest revenue and (b) holding gain from improved credit standing 12/08 12/09 AAA Anaheim Teaching Fair ValueConcepts and Measurements

36 Teaching Fair ValueConcepts and Measurements
Loan Agreement-D 12/08 HG = 1,506K Int = 0 $10M All income assigned to holding gain from improved credit standing 12/08 12/09 AAA Anaheim Teaching Fair ValueConcepts and Measurements

37 Teaching Fair ValueConcepts and Measurements
Loan Agreement-D 12/08 HG = 279K Int = 1,227K $10M Interest revenue accrued at 12.27% for year, then holding gain at end of year from improved credit standing 12/08 12/09 AAA Anaheim Teaching Fair ValueConcepts and Measurements

38 Teaching Fair ValueConcepts and Measurements
Loan Agreement-D 12/08 HG = 642K Int = 864K $10M Interest revenue accrued at original rate of 8% on original balance of $10,800, then holding gain brings to fair value 12/08 12/09 AAA Anaheim Teaching Fair ValueConcepts and Measurements

39 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements

40 Teaching Fair ValueConcepts and Measurements
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 AAA Anaheim Teaching Fair ValueConcepts and Measurements


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