Problem 19-6 Using interest rate swap as a cash flow hedge.

Basie Business Forms borrowed $5 million on July 1, 20X1, from First Kansas City Bank. The loan required annual interest payments at the LIBOR rate, reset annually each June 30. The loan principal is due in five years. The LIBOR rate for the first year is 6.0%. Basie decided to swap its variable interest payments for fixed interest payments of 6.0%. Basie will pay 6.0% interest to the swap counterpartyQuincy Bank & Trustand receive LIBOR payments based on a $5 million notional amount for the entire five-year term of the original loan. Payments and receipts occur on a net basis. The swap has no value at its inception on July 1, 20X1. Basie designates the swap as a hedge of its cash flow exposure to interest rate risk on its variable rate debt. The hedge is fully effective because the key terms of the loan and swap are identical. The variable rate was reset to 6.25% on June 30, 20X2, and to 5.75% on June 30, 20X3. Basie uses a June 30 fiscal year-end and records interest expense annually.

Required:

1. How much net cash settlement will Basie pay to (or receive from) Quincy Bank & Trust on July 1, 20X2? On July 1, 20X3?
2. How much cash will Basie pay to First Kansas City Bank on July 1, 20X2? On July 1, 20X3?
3. On June 30, 20X2, the swap has a fair value of $40,000 based on dealer quotes. Prepare journal entries to record Basies cash interest payments and receipts, change in swap value, and its interest expense for the year ended June 30, 20X2.
4. On June 30, 20X3, the swap has a fair value of $(28,000), a negative amount. Prepare journal entries to record Basies cash interest payments and receipts, change in swap value, and its interest expense for the year ended June 30, 20X3.