Question

Vulture Ltd. is incorporated to invest in risky securities. On January 1, 2015, the company buys Volatile Ltd. bonds with a par value of $ 10,000. Vulture plans to hold these bonds until they mature in two years, on December 31, 2016. The bonds pay 5% interest, paid on December 31 of each year.
Volatile Ltd. is in financial distress, and payment of interest and principal on December 31, 2016, depends on whether Volatile Ltd. recovers from its financial problems. The probability that it will recover is 0.7 in which case Vulture Ltd. will receive full interest and principal. If Volatile does not recover, Vulture will receive no interest on December 31, 2016, and the bonds will be worth half of par value. Vulture finances the bond purchase by issuing common shares. The interest rate in the economy is 5%, which is also Vulture’s cost of capital.

Requirements
a. How much did Vulture Ltd. pay for the Volatile Ltd. bonds?
b. In December 2015, it becomes apparent that Volatile Ltd. has recovered. Prepare a Vulture Ltd. balance sheet at the end of 2015 and an income statement for 2015.
c. Suppose instead that Vulture accounts for its bond investment under IFRS 9. Vulture’s business model specifies that bond investments are intended to be held so as to collect interest and principal. Assuming that Vulture paid the amount for the bonds as calculated in part a, what would be its balance sheet valuation of its Volatile investment on December 31, 2015, and Vulture’s net income for 2015?
d. Suppose now that Vulture’s business model allows it to sell investments at any time. It contracts in December 2015 to sell its Volatile bond investment on January 1, 2016, for $ 9,600. Assume that Vulture accounts for its investments under IFRS 9. What would be the balance sheet valuation of its Volatile investment on December 31, 2015, and Vulture’s net income for 2015?



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  • CreatedSeptember 09, 2014
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