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?


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


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


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


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


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”


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?


Measurements 9

Equity Investment

Case 1: Solution Single share is unit of account (para 27) Level 1 asset Use closing bid price (para 31)


Measurements 10

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


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


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?


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?


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


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


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


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?


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?)


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)3

r = 12.27%


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)3

r = 8.24%


Measurements 21

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%


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


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)


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


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


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?


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?


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


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) = $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


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


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%


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%)


Measurements 33

Loan Agreement-D

Case 2(D): The Issues Dividing income into interest income and holding

gains and losses


Measurements 34

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


Measurements 35

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


Measurements 36

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


Measurements 37

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


Measurements 38

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


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


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

Documents

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