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Fair Value Option Homework Assignments HW #3Problem 1 Fair Value Option (similar to illustration in K. Stice’s material posted on web site)Problem 2 – Fair Value Option but a more realistic example (similar to one in ppt slides)Problem 3. Valuing of Bonds Held as Investment Securities – market values are available.Problem 4 – Disclosures for Items Reported at Fair Value on a Recurring BasisProblem 5 – Disclosures for Items Reported at Fair Value on a NONRecurring BasisProblem 6 - This is the fair value portion of HW#2, Problem 3Acct 414 – Spring 2011 Prof. T. Gordon Fair Value Option Homework Assignments HW #3 Problem 1 Fair Value Option (similar to illustration in K. Stice’s material posted on web site) Ryan Marie Company has one asset, a bond issued by Miles Company that Ryan Marie purchased (on the day it was issued) as an investment. Ryan Marie also has only one liability, one of its own bonds that was to finance the purchase of the Miles Bond investment. The company had no initial shareholder investment. Both bonds have the same terms: $1,000 face value, 10-year life, 11% coupon rate, and single interest payments made at the end of each year. On their issuance dates, both bonds were associated with a market interest rate of 8%. The company has determined to account for both the bond asset and the bond liability using the fair value option. 1. Prepare a balance sheet for Ryan Marie Company as of the date it both purchased the Miles bond investment and issued its own bonds payable. 2. On the very next day, the market interest rate with respect to the Miles bond investment had risen to 13%, and the market interest rate with respect to Ryan Marie’s bond had risen to 11%. Prepare the company’s balance sheet. 3. Repeat (2) but this time assume that the market interest rate for the Miles bond had gone down to 6%, and the market interest rate of Ryan Marie bond had increased to 14%. 4. Repeat (2) but this time assume that the market interest rate for the Miles bond had increased to 14%, and the market interest rate of Ryan Marie bond had gone down to 6%. Problem 2 – Fair Value Option but a more realistic example (similar to one in ppt slides) Margaret Inc. has one asset, a bond issued by Mead Company that Margaret Inc. purchased at face value as an investment (accounted for at fair value as trading security). Margaret Inc. has only one liability, a bond that was issued at face value to finance the purchase of the Mead Company bond. There is no initial shareholder investment. Terms of the bonds Mead Company Bond Investment Margaret Inc. Bond Payable Face value $100,000 $100,000 Coupon rate (annual) 12% 10% Term 10 years 8 years Semiannual interest payment $6,000 $5,000 Yield rate at year end (simple interest) 11% 9% What makes this one different from #1? The balance sheets are prepared a year later instead of “next day” and the bonds are semiannual. In both cases, the bonds are not actively traded but yield rates for bonds with similar ratings and maturities are available (level 2 inputs in the fair value hierarchy): Required: a. Prepare a balance sheet and income statement for Margaret Company at the END of the first year assuming that the fair value option was not selected for the bond payable. Hint – do an income statement first. b. Prepare a balance sheet and income statement for Margaret Company at the END of the first year assuming that the fair value option was selected for the bond payable. c. Prepare a balance sheet and income statement for Margaret Company and the END of the first year assuming that the fair value option was selected for the bond payable and the bond investment is accounted for as part of the available for sale securities portfolio (instead of the trading securities portfolio).Acct 414 HW #2 (continued) Page 2 Problem 3. Valuing of Bonds Held as Investment Securities – market values are available. Han Company has purchased five corporate bonds as temporary investments. The bond investments are to be reported in Han’s books at their fair values on the balance sheet date. “Fair value” is defined as the price that would be received to sell an asset in an orderly transaction between market participants. Each of the bonds has unique terms, and the bonds are not traded in active markets, so Han cannot look to quoted market prices to directly determine how much each bond would bring in a sales transaction. However, Han has assembled the following matrix of bond price data for actively traded bonds which can be used to indirectly estimate the selling price of each of Han’s bonds. Bond Prices (% of par) Bond RatingsTerm (in years)AAAAAA BBB BB2 103.85 103.56 102.71 102.37 100.295 103.66 102.53 101.45 100.17 98.5010 101.64 100.29 99.56 98.54 91.9820 95.66 91.49 90.00 89.31 82.06 Han has learned that the selling price of a bond is related to both its term (the number of years until the bond matures) and by the underlying riskiness of the company that issued the bond. [Note: Another important valuation variable is the amount of interest paid by the bond. In this example, that rate is assumed to be the same for all bonds and so is ignored in this analysis.] This underlying riskiness is represented by the “bond rating” which is a label attached to a bond by a bond rating agency such as Standard & Poor’s. The rating agency assigns the rating after an analysis of the bond issuing company’s finances and the strength of its industry. A lower bond rate (AAA is the highest in the table and BB is the lowest) indicates that rating agency views the bond issuing company as being more risky. The higher this risk, the lower the bond price if everything else is held constant. Also, somewhat independent of the underlying riskiness of the bond issuing company, the longer until a bond matures the more risk is associated with a bond. Thus, holding all else constant, bonds with longer times to maturity have lower prices. For the five bonds it purchased, Taraz has determined the time to maturity and has also looked up the bond rating from Standard & Poor’s. These data for the five bonds are as follows. BondTermRatingBond 1 15 AABond 2 6 BBBBond 3 3 AAABond 4 18 BBBond 5 9 A Question: Estimate the fair value of each of the five bonds. Note: The par value of each of the bonds is $1,000, and the numbers given in the matrix of bond prices are expressed in terms of a percentage of par value.Acct 414 HW #2


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