Chapter 7
Financing Activities
7-21
in whole or in part.
d. GAAP does not require a specific option-pricing model. However, any model
must incorporate a variety of factors, including the exercise price of the option,
Scholes model, primarily because (1) earlier FASB pronouncements required its
use and (2) it is fairly easy to apply because it is a defined equation. Students’
are better captured in lattice-based models.
7.22 Interpreting Stock Option Disclosures.
a. Firms structure stock option plans so that a period of time elapses between the
grant date and the date the option becomes in the money (defined as the exercise
price less than the current market price of the stock). Setting the exercise price
b. The fair value of the options granted increased between Year 2 and Year 3 in
part because the market price of the firm’s common stock increased between
d. Many firms have concluded that the forgone cash flows from selling shares of
flected in a higher stock price over time.
e. The firm would report compensation expense of $424.55 million for Year 2
that follows.)
Chapter 7
Financing Activities
7-22
in whole or in part.
f. (1) This method ignores the economic cost to the firm and the benefit to
employees of the option to purchase shares for less than their market
(2) This method attempts to measure the value of options at the time of the
grant and to recognize the cost of the options over the expected period until
tions over a period of one to five years, yet the expected period until exer-
cise is six years. This approach does not recognize expenses during the last
several years that the options from any particular year are outstanding.
(3) This method recognizes the ultimate, realized benefit to employees and the
services.
Chapter 7
Financing Activities
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in whole or in part.
7.23 Hedging Interest Rate Risk
SOLUTION TO PART A
The following schedule summarizes the financial statement effects. Explanations follow.
Fair Value Hedge: Interest Rate Swap to Convert Fixed-Rate Debt to Variable-Rate
Debt
Assets = Liabilities + Shareholders’ Equity
CC AOCI RE
January 1, 2013
Equipment +500,000 Notes Payable +500,000
Equipment +500,000
Notes Payable +500,000
December 31, 2013
Interest expense on note:
Cash –20,000 Interest Expense –20,000
Revaluation of note:
Notes Payable +14,143 Loss on Revaluation
of Notes Payable –14,143
Revaluation of Swap Contract:
Swap Contract +14,143 Gain on Revaluation
Swap Contract 5,000
Notes Payable 18,864
Gain on Revaluation of Notes Payable 18,864
Loss on Revaluation of Swap Contract 18,864
Swap Contract 18,864
December 31, 2015
Interest expense on note:
January 1, 2013
January 31, 2013
• Because interest rates declined to 3% during 2013, the bank resets the interest rate
to 3% for 2014. FD must restate the note payable to fair value and record the
Chapter 7
Financing Activities
7-25
in whole or in part.
Note Payable on the income statement in the same amount.
riods at 3% is $14,143. Thus, the value of the swap contract increased from zero
contract) in hedging the interest rate risk.
December 31, 2014
• FD records interest expense on the note payable using the effective interest me-
thod. The effective interest rate for 2014 is 3%, and the book value of the note
$4,576.
• FD records an increase in the swap contract asset due to the passage of time ($424
= 0.03 × $14,143) and the associated interest revenue. Recall that the swap con-
tract was originally valued using present value; thus, its present value increases
by the amount of interest each year. Interest expense (net) as a result of the two
• FD must revalue the note payable and the swap contract for changes in fair value.
Interest rates increased during 2014, so the bank resets the interest rate in the
swap agreement to 5% for 2015. The present value of the remaining payments on
the note (two cash interest payments of $20,000 and one maturity payment of
contract becomes a liability instead of an asset. When discounted at 5%, the
Chapter 7
Financing Activities
7-26
in whole or in part.
revaluation of the note exactly offsets the loss on revaluation of the swap contract,
so the swap contract hedges the change in interest rates.
December 31, 2015
cash.
value of the note.
• FD must pay the counterparty an extra 1% because the variable interest rate of 5%
• The interest rate does not change, so no additional revaluations are necessary.
Chapter 7
Financing Activities
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in whole or in part.
SOLUTION TO PART B
The following schedule summarizes the financial statement effects. Explanations follow.
Cash Flow Hedge: Interest Rate Swap to Convert Variable-Rate Debt to
Fixed-Rate Debt
Assets = Liabilities + Shareholders’ Equity
CC AOCI RE
January 1, 2013
Equipment +500,000 Notes Payable +500,000
Equipment +500,000
Notes Payable +500,000
December 31, 2013
Interest expense on note:
Cash –20,000 Interest Expense –20,000
December 31, 2014
Interest expense on note:
Cash –15,000 Interest Expense –15,000
Interest “expense” (OCI) on
swap contract liability:
Swap Contract +424
OCI—Swap
Contract –424
Cash payment to counterparty:
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Financing Activities
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in whole or in part.
December 31, 2015
Interest expense on note:
Cash –25,000 Interest Expense –25,000
Interest “revenue” (OCI) on
swap contract assets:
Swap Contract +465
OCI—Swap
Contract +465
Interest Expense 25,000
Cash 25,000
Swap Contract 465
January 1, 2013
December 31, 2013
The fair value of the note in this case, unlike Scenario 1, will not change as interest rates
change because the note carries a variable interest rate. However, the fair value of the
accumulated other comprehensive income, a shareholders’ equity account).
December 31, 2014
• FD pays the (now) $15,000 interest on the variable-rate note and recognizes
interest expense.
Chapter 7
Financing Activities
7-29
in whole or in part.
swap contract and reduces the swap contract liability. Because the swap contract
hedged cash flows related to interest rate risk during 2014, FD reclassifies a equal
portion of other comprehensive income to net income. At this point, the swap
asset by $9,297. Removing the liability and recognizing the asset increases 2014
other comprehensive income by the sum of the two, $18,864. At this point, other
comprehensive income for 2014 is $23,440 ($5,000 + $18,864 – $424), which in-
December 31, 2015
contract requires the counterparty to pay the firm $5,000 under the swap contract,
which reduces the swap contract asset by $5,000.
– $5,000).
In summary, note that interest expense is $20,000 each year, the fixed rate of 4% that FD
obtained by entering into the swap contract. The amounts in other comprehensive income
reflect changes in the fair value of the swap contract.
Chapter 7
Financing Activities
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in whole or in part.
Integrative Case 7.1: Starbucks
a. Lease Present Value Present
Lease Payment in: Payment Factor at 6.25% Value
2013 $ 787.9 0.9412 $ 741.6
2014 728.5 0.8858 645.3
periods, then discounted back five periods.
b. Adjust the numerator and denominator for the present value of the operating
Long-Term Debt to Long-Term Capital Ratio (adjusted)
Replace the book value of equity ($5,109.0) with an approximation of the market
market values of debt and equity)
d. The debt ratios with capitalization of operating leases increase significantly for
Starbucks, indicating more capital structure risk compared to when the ratios
Using fair values in the ratio causes Starbucks to appear less risky. A good case
could be made that fair values aid risk assessment a great deal. Empirical re-
also lead to a higher association.