Question

In: Finance

A) An excerpt from Johnson & Johnson: “As of December 31, 2017, the balance of deferred...

A) An excerpt from Johnson & Johnson:

“As of December 31, 2017, the balance of deferred net gains on derivatives included in accumulated other comprehensive income was $70 million after-tax. The Company expects that substantially all of the amounts related to forward foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period.”

What is meant by “reclassified into earnings”? What type of hedging transaction is mentioned?

B) Caesar’s Casino (WILL NOT BE GRADED. WE WILL SOLVE THIS IN CLASS)

On January 1, 2015, Ceasar’s Casino, a public business entity (Ceasar’s or the “Company”), executed a $250 million revolving credit facility with Uber Bank AG (Uber). The rate of interest on the credit facility is USD LIBOR + 650 basis points (bps) for the first two years. Ceasar’s has a choice of 1M-, 3M-, and 6M-USD LIBOR each time it draws down on the credit facility. Interest payments on the borrowing are settled on the basis of the LIBOR tenor selected (e.g., if Ceasar’s selects three-month USD LIBOR as the referenced rate, interest is due every three months on that borrowing). Principal borrowed is typically due five years from the drawdown date, but each drawdown will contain a specified maturity date.

Upon finalizing the terms of the credit facility, Ceasar’s immediately drew down $50 million on January 1, 2015, at 3M-USD-LIBOR + 650 bps, due on December 31, 2019. Ceasar’s’s interest rate risk management policy requires that at least 75 percent of its outstanding debt be fixed rate (either directly or indirectly through the use of derivatives). To maintain compliance with its policy, Ceasar’s entered into an interest rate swap to “convert” the borrowing from variable to fixed interest.

The Company designated the interest rate swap as a hedge of forecasted interest payments associated with changes in 3M-USD-LIBOR on the first previously unhedged $50 million of 3M-USD-LIBOR based debt. The Company has no other debt. Specifically, Ceasar’s executed the following interest rate swap transaction:

• Notional amount: $50 million

• Trade date: January 1, 2015

• Effective date: January 1, 2015

• Maturity date: December 31, 2019

• Pay leg: 8.0 percent

• Receive leg: 3M-USD-LIBOR + 650 bps

• Initial LIBOR: 1.00 percent

• Payment dates: Each March 31, June 30, September 30, and December 31

• Variable reset dates: Quarterly, each March 31, June 30, September 30, and December 31.

Questions

1. Define the type of hedge that Ceasar’s would need to designate. In other words, are these cash flow hedges, fair value hedges, or net investment hedges?

2. Determine the journal entries to account for the hedging relationship between January 1, 2015 and June 30, 2015. Use the details below to aid in entry determination, and assume that the hedging relationship is perfectly effective.

Date 3M-USD-LIBOR Swap Fair Value

March 31, 2015 1.00% (reset 12/31) $250,000

June 30, 2015 1.10% (reset 03/31) $750,000

Solutions

Expert Solution

A).

Reclassified into earnings refers to the moving of sum of profits or loss from one account to another general ledger account. Reclassification helps to the investor from losses at the time of situation of inflation.

As per the given example, the forward foreign exchange contracts which is the type of hedging transaction is mentioned. In forward foreign exchange contracts, it is mention that the two parties are agreed to buy or sell the assets at the future fixed date or amount. It removes the doubt of future changes in the value of exchange rate. This agreement helps in abolishing the risk of losses from the negative type of markets. Also, this agreement abolishing the earnings of more amount of profits in the favorable market. This agreement ensures the individuals to get back same money in future which they invest in the particular securities. Therefore, in the given case the amount of comprehensive income is reclassified in order to avoid the losses.

B).

The three types of hedges are as mentioned below:

Fair value hedges: In the fair value hedges, the risk of uncertainty for fair value of an asset is eliminated. For example: Under fair value hedges, the amount of fair value of an asset is being save from the value of interest rates and foreign exchange rates.
Cash flow hedges: In the cash flow hedges, the risk of uncertainty for cash inflow and outflow which arises due to the change in interest rate and exchange rate of currency.
Net investment hedges: In the net investment hedges, the risk of uncertainty for net imports and exports has been eliminated which arises due to the change in interest rate and exchange rate of currency.

Therefore, as per the given case the fair value hedges would need to designate for Cesars’s because the interest rate that is LIBOR increases and it affects the fair value of the assets of particular country or organization. So, for reducing the situation of losses Ceasar should consider the benefits of fair value hedges and implement it.

Journal Entries for hedging relationship:

Hedging of fair value of an asset is increased. Therefore, derivatives account is debited with $500,000.
In hedging of fair value of an asset company is bearing a loss. Therefore, Profit and loss account is credited with $500,000.

jeff jeffy answered 1 month ago

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