Question

Problem A-1 (Algo) Derivatives; interest rate swap [LOA–2]

On January 1, 2021, Labtech Circuits borrowed $250,000 from First Bank by issuing a three-year, 6% note, payable on December 31, 2023. Labtech wanted to hedge the risk that general interest rates will decline, causing the fair value of its debt to increase. Therefore, Labtech entered into a three-year interest rate swap agreement on January 1, 2021, and designated the swap as a fair value hedge. The agreement called for the company to receive payment based on an 6% fixed interest rate on a notional amount of $250,000 and to pay interest based on a floating interest rate tied to LIBOR. The contract called for cash settlement of the net interest amount on December 31 of each year.

Floating (LIBOR) settlement rates were 6% at inception and 7%, 5%, and 5% at the end of 2021, 2022, and 2023, respectively. The fair values of the swap are quotes obtained from a derivatives dealer. These quotes and the fair values of the note are as follows:

	January 1			December 31
	2021			2021			2022			2023
Fair value of interest rate swap		0		$	(3,259	)	$	2,435		$	0
Fair value of note payable	$	250,000		$	246,741		$	252,435		$	250,000

Required:
1. Calculate the net cash settlement at the end of 2021, 2022, and 2023.
2. Prepare the journal entries during 2021 to record the issuance of the note, interest, and necessary adjustments for changes in fair value.
3. Prepare the journal entries during 2022 to record interest, net cash interest settlement for the interest rate swap, and necessary adjustments for changes in fair value.
4. Prepare the journal entries during 2023 to record interest, net cash interest settlement for the interest rate swap, necessary adjustments for changes in fair value, and repayment of the debt.
5. Calculate the book values of both the swap account and the note in each of the three years.
6. Calculate the net effect on earnings of the hedging arrangement in each of the three years. (Ignore income taxes.)
7. Suppose the fair value of the note at December 31, 2021, had been $237,000 rather than $246,741 with the additional decline in fair value due to investors’ perceptions that the creditworthiness of Labtech was worsening. How would that affect your entries to record changes in the fair values?

Answer 1

ANSWER:

1) Determine the net cash settlement for the year 2021 First Compute fixed interest receipts Notional Amount 250,000/ Fixed interest Rate 6% X Time period = 1 = Fixed interest receipts 15000 Then, Compute floating interest payments Notional Amount 250,000 Floating interest ratex 7% * Time period 1 = Floating interest payments 17500 Amount Compute net interest reciepts Particulars Fixed interest receipts Floating interest payments Net interest reciepts (payments) 15000 (17,500) (2,500) Determine the net cash settlement for the year 2022 First Compute fixed interest receipts Notional Amount 250,000/ Time period = Fixed interest Rate 6% X Fixed interest receipts 15000

Then, Compute floating interest payments Notional Amount 250,000 X Floating interest ratex 5% X Time period = 1 = Floating interest payments 12500 Amount Compute net interest reciepts Particulars Fixed interest receipts Floating interest payments Net interest reciepts (payments) 150001 (12,500) 2,500 Determine the net cash settlement for the year 2023 First Compute fixed interest receipts Notional Amount x 250,000 X X Fixed interest Rate 6% X Time period = 1 = Fixed interest receipts 15000 Then, Compute floating interest payments Notional Amount 250,000 Floating interest rate 5% X Time period 1 = Floating interest payments 12500 Amount Compute net interest reciepts Particulars Fixed interest receipts Floating interest payments Net interest reciepts (payments) 15000 (12,500) 2,500

2) Journalize the transactions for 2021 Issue of note Date Jan 1,2021 Debit Particulars Cash Notes Payable (To record issuance of note) Credit 250,000 250,000 Interest expense payment Date Dec 31, 2021 Credit 15,000 Particulars Debit Interest expense Cash (To record interest expense payment 15,000 Net interest reciept Date Dec 31, 2021 Particulars Debit Interest expense Cash (To record net interest settlement Credit 2,500 2,500

Changes in fair value of interest swap Date Dec 31, 2021 Particulars Debit Holding loss-interest rate swap Interest rate swap (To record decrease in fair value from 0 to (3259)) Credit 3,259 3,259 Changes in fair value of note Date Particulars Debit Credit Dec 31, 2021 Note payable 3,259 Holding gain-Hedged note 3,259 (To record decrease in value from 250,000 to 246,741) 3) Journalize the transactions for 2022 Interest expense payment Date Particulars Debit Credit Dec 31,2022 Interest expense 15,000 Cash 15,000 (To record interest expense payment Net interest reciept Date Dec 31,2022 Particulars Debit Cash Interest expense (To record net interest settlement Credit 2,500 2,500

Changes in fair value of interest swap Date Credit Dec 31,2022 Particulars Debit Interest rate swap 5,694 Holding gain-Interest rate swap (To record decrease in fair value from (3259) to 2435) 5,694 Changes in fair value of note Credit Date Dec 31,2022 Particulars Debit Holding loss- Hedged note 5,694 Note payable (To record decrease in value from 246,741 to 252,435) 5,694 Credit 15,000 15,000 4) Journalize the transactions for 2023 Interest expense payment Date Particulars Debit Dec 31, 2023 Interest expense Cash (To record interest expense payment Net interest reciept Date Particulars Debit Dec 31, 2023 Cash Interest expense (To record net interest settlement Credit 2,500 2,500

Changes in fair value of interest swap Date Credit Dec 31, 2023 2,435 Particulars Debit Holding loss-interest rate swap Interest rate swap (To record decrease in fair value from 2435 to 0) 2,435 Changes in fair value of note Date Dec 31, 2023 Particulars Debit Credit Note payable 2,435 Holding gain-Hedged note 2,435 (To record decrease in value from 252,435 to 250,000) Repayment of note Debit Credit Date Dec 31, 2023 250,000 Particulars Note payable Cash (To record note being paid) 250,000 As per HomeworkLib policy, only first 4 subparts need to be solved