Question

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Exercise A-4 (Algo) Derivatives; interest rate swap; fixed rate debt; fair value change unrelated to hedged risk (LOA-2] Ipped LLB Industries borrowed $280,000 from Trust Bank by issuing a two-year, 10% note, with interest payable quarterly. LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional amount of $280,000 and to pay interest based on a floating interest rate. Book Floating (LIBOR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30, 2021. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June 30 was due to investors' perceptions that the creditworthiness of LLB was improving. Hint Fair value of interest rate swap Fair value of note payable January 1 0 $ 280,000 March 31 $ 7,272 $287,272 June 30 $ 12,994 $ 300,000 Print Required: 1. Calculate the net cash settlement at June 30, 2021. 2. Prepare the journal entries on June 30, 2021, to record the interest and necessary adjustments for changes in fair value.

Answer 1

Requirement 1 January 1 $ Fair value of interest rate swap Fair value of note payable Fixed rate Floating Rate Fixed interest receipts Floating payments Net cash settlement 2,80,000 10% 10% March 31 June 30 $ 7,272 $ 12,994 $ 2,87,272 $ 3,00,000 10% 10% 8% 6% $ 7,000 $ 7,000 $ 5,600 $ 4,200 $ 1,400 $ 2,800 Requirement 2 Credit Date 1.1.2021 Account Cash Notes Payable Debit $ 2,80,000 $ 2,80,000 Date 31.3.2021 7,000 1,400 Account Debit Credit Interest expense $ 7,000 Cash $ (To record interest) Cash $ 1,400 Interest expense $ (To record the net cash settlement) Interest rate swap $ 7,272 Holding gain-interest rate sw $ (To record change in fair value of the derivative) Holding loss-hedged note $ 7,272 Notes Payable $ (To record change in fair value of the note) 7,272 7,272 Date 30.6.2021 7,000 2,800 Account Debit Credit Interest expense $ 7,000 Cash $ (To record interest) Cash $ 2,800 Interest expense $ (To record the net cash settlement) Interest rate swap $ 5,722 Holding gain-interest rate sw. $ (To record change in fair value of the derivative) Interest expense $ 5,722 Notes Payable $ (To record change in fair value of the note) 5,722 5,722