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Two Cases on Financial Assets and Liabilities

Two Cases on Financial Assets and Liabilities. Ross Jennings University of Texas at Austin. 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?

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Two Cases on Financial Assets and Liabilities

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  1. Two Cases on Financial Assets and Liabilities Ross JenningsUniversity of Texas at Austin

  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? 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 Teaching Fair ValueConcepts and Measurements

  4. 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 Teaching Fair ValueConcepts and Measurements

  5. 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 Teaching Fair ValueConcepts and Measurements

  6. 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 Teaching Fair ValueConcepts and Measurements

  7. 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” Teaching Fair ValueConcepts and Measurements

  8. 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? Teaching Fair ValueConcepts and Measurements

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

  10. Equity Investment • Case 1: SolutionQuarter 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 Quarter End Holding Gain Purchase Day Holding Gain Teaching Fair ValueConcepts and Measurements

  11. 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 Teaching Fair ValueConcepts and Measurements

  12. 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? Teaching Fair ValueConcepts and Measurements

  13. 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? Teaching Fair ValueConcepts and Measurements

  14. 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 Teaching Fair ValueConcepts and Measurements

  15. 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 Teaching Fair ValueConcepts and Measurements

  16. 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 Teaching Fair ValueConcepts and Measurements

  17. 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? Teaching Fair ValueConcepts and Measurements

  18. 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?) Teaching Fair ValueConcepts and Measurements

  19. 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)3r = 12.27% Teaching Fair ValueConcepts and Measurements

  20. 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)3r = 8.24% Teaching Fair ValueConcepts and Measurements

  21. Loan Agreement-B • Case 2(B): Solution 12/08 12/09 12/10 12/11Contracted 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% Teaching Fair ValueConcepts and Measurements

  22. 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 Teaching Fair ValueConcepts and Measurements

  23. 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) Teaching Fair ValueConcepts and Measurements

  24. 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 Teaching Fair ValueConcepts and Measurements

  25. 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 Teaching Fair ValueConcepts and Measurements

  26. 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? Teaching Fair ValueConcepts and Measurements

  27. 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? Teaching Fair ValueConcepts and Measurements

  28. 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 Teaching Fair ValueConcepts and Measurements

  29. 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) = $200Kand 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 Teaching Fair ValueConcepts and Measurements

  30. 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 Teaching Fair ValueConcepts and Measurements

  31. 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% Teaching Fair ValueConcepts and Measurements

  32. 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%) Teaching Fair ValueConcepts and Measurements

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

  34. Loan Agreement-D • Case 2(D): Solution • Beginning value for 2009 is $10 millionEnding 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 $11,506Change equals income of $11,506 – $10,000 = $1,506 Teaching Fair ValueConcepts and Measurements

  35. 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 Teaching Fair ValueConcepts and Measurements

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

  37. Loan Agreement-D 12/08 HG = 279KInt = 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 Teaching Fair ValueConcepts and Measurements

  38. Loan Agreement-D 12/08 HG = 642KInt = 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 Teaching Fair ValueConcepts and Measurements

  39. 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 Teaching Fair ValueConcepts and Measurements

  40. 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 Teaching Fair ValueConcepts and Measurements

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