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Chatham - Debt Valuations in Accordance with FAS 157 (ASC 820)

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White Paper: Debt Valuations in Accordance with FAS 157 (ASC 820) Background and Summary Debt fair values are nothing new to financial reporting. They have been required for years as a FAS 107 (ASC 825) footnote disclosure. More recently, with the introduction of FAS 157 (ASC 820), fair values in general have received increased attention. However, the fundamental concepts of debt valuations have not changed. Only the level of detail and scrutiny that will go into validating the assumptions in those valuations has increased. To better describe Chatham's approach to debt valuations, we will review ASC 820 as it applies to debt valuations, look at the key factors affecting valuations, and review the fixed income concepts that make up our discounted cash flow valuation model for debt. Debt Fair Values and Accounting Guidance ASC Topic 820, Fair Value Measurements (the Standard), defines fair value as the price that would be received to sell an asset, or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When there is an active market with quoted prices for the identical debt instrument being valued, the application of the accounting guidance is relatively straight-forward with the fair value of the instrument equal to that market price. Unfortunately, many debt instruments do not actively trade in secondary markets with quoted prices. The problem is further exacerbated by difficultly in determining just what constitutes an active market in the current credit market environment. Absent having a quoted price in an active market for the identical debt instrument being valued, the valuation of the debt instrument is predicated on what the Standard defines as Level 2 and Level 3 inputs. Level 2 inputs are things other than quoted prices for the identical debt instrument being valued and are observable for substantially the full term of the asset or liability. Level 2 inputs generally include interest rates and yield curves that are observable at commonly quoted intervals. Any other inputs needed to value the debt instrument that are unobservable, or not quoted or observable, for substantially the full term of the debt instrument, are considered Level 3 inputs for purpose of the valuation. Credit and interest rate spread information is generally considered unobservable. Of particular conceptual difficulty is the requirement in ASC 820 that fair value of issued debt (borrowings) be the price that would be paid to transfer that liability to another party with similar credit risk in which the liability is assumed to continue and not to be settled. In other words, the Standard requires that the nonperformance risk of the liability be reflected in the value of that liability. From a conceptual standpoint, if the liability was assumed to be settled there would be no non-performance risk to consider. Nonperformance risk refers to the risk that the obligation (the liability to the counterparty) will not be fulfilled. This nonperformance risk includes the reporting entity's own credit risk, as well as changes in market credit spreads over time. Ultimately, the goal of the application of ASC 820 fair value guidance with respect to liabilities is to allow the reporting entity to reflect the relative efficiency of its ability to settle the liability using its own internal resources over the course of its settlement, not before. To the extent a reporting entity could borrow debt at market rates that are more favorable than the rates they have contractually agreed to in their existing debt instruments, the company has an economic loss and fair value loss. To the extent a reporting entity has existing debt instruments at contractual rates that are much lower than what the Company could obtain under current market conditions, the Company has an economic gain and fair value gain. Debt Valuation Methodology According to Brealy and Meyers in their Principals of Corporate Finance, the valuation of debt is simple – "you [just] take the cash flows and discount them at the opportunity cost of capital" (669). While conceptually this may be simple, determination of the discount rate(s) can be quite challenging. The opportunity cost of capital from the

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