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Fair Value Measurements & Derivative Instruments
 9 Months Ended
Jun. 30, 2011
Fair Value Measurements & Derivative Instruments  
Fair Value Measurements & Derivative Instruments

NOTE 8. FAIR VALUE MEASUREMENTS & DERIVATIVE INSTRUMENTS

The Company measures its financial assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Additionally, the Company is required to provide disclosure and categorize assets and liabilities measured at fair value into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. Financial assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows:

Level 1—Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices in markets that are not active for which significant inputs are observable, either directly or indirectly.

Level 3—Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management's best estimate of what market participants would use in valuing the asset or liability at the measurement date.

The following table summarizes fair value measurements at June 30, 2011 for assets and liabilities measured at fair value on a recurring basis:

 

     Level I      Level II      Level III      Total  

Cash and cash equivalents

    $ 4,316,308       $ —         $ —         $ 4,316,308   

Marketable securities

    $ 1,177,708       $ —         $ —         $ 1,177,708   

Derivative assets

    $ —         $ —         $ 284,625       $ 284,625   

Derivative liabilities

    $ —         $ —         $ 958,451       $ 958,451   

As part of the sale of Unidym in January 2011, Arrowhead received common stock in Wisepower, originally valued at $2.5 million, $100,000 of which is due to a third party. Arrowhead has the ability to sell the shares of stock in Wisepower, subject to certain limits on volume of sales over a nine-month period ending in October 2011. During the nine months ended June 30, 2011, Arrowhead sold approximately 40% of the original holdings; the remaining shares had a market value of $1.2 million at June 30, 2011. The recorded value of the stock is adjusted to fair market value based on quotations from the KOSDAQ, a Korean stock exchange, and published foreign exchange rates. Marketable securities are included as part of other current assets in the Company's consolidated balance sheet.

As part of the sale of Unidym in January 2011, Arrowhead received a bond from Wisepower in the face amount of $2.5 million. The bond is convertible to Wisepower common stock beginning on January 17, 2012 at a price of $2.00 per share. The conversion feature is subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the conversion feature on the date of issuance was estimated using an option pricing model and recorded on the Company's consolidated balance sheet as a derivative asset. The fair value of the conversion feature is estimated at the end of each reporting period and the change in the fair value of the conversion feature is recorded as a nonoperating gain/loss as change in value of derivatives in Company's consolidated statement of operations. A portion of the bond is owed to a third party, as such the company records a derivative asset for entire conversion feature and records a derivative liability for the portion related to the third party. The original fair value of the derivative relating to the third party was $26,310; the fair value at June 30, 2011 was $12,107. The gain of $14,203 is reflected in the change in value of derivatives in the Company's consolidated statement of operations.

 

During the nine months ended June 30, 2011, the Company recorded a loss from the change in fair value of the derivative asset of $333,875. The assumptions used in valuing the derivative asset as of June 30, 2011 were as follows:

 

Risk free interest rate

      0.8 % 

Expected life

      2.6 Years   

Dividend yield

      none   

Volatility

      72 % 

The following is a reconciliation of the derivative asset for the nine months ended June 30, 2011:

 

Value at October 1, 2010

    $ —     

Receipt of instruments

      618,500   

Decrease in value

      (333,875 ) 

Net settlements

      —     
        

Value at June 30, 2011

    $ 284,625   
        

As part of the equity financing on June 17, 2010, as described in Note 5, Arrowhead issued warrants to acquire up to 3,296,497 shares of common stock (the "Warrants") which contain anti-dilution protection. Under the certain provisions of the Warrants, if, during the term of the Warrants, the Company issues Common Stock at a price lower than the exercise price of the Warrants, the exercise price of the Warrants would be reduced to the amount equal to the issuance price of the Common Stock. Because the Warrants have this feature, the Warrants are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the Warrants on the date of issuance was estimated using an option pricing model and recorded on the Company's consolidated balance sheet as a derivative liability. The fair value of the Warrants is estimated at the end of each reporting period and the change in the fair value of the Warrants is recorded as a nonoperating gain or loss in the Company's consolidated statement of operations. During the nine months ended June 30, 2011, the Company recorded a gain from the change in fair value of the derivative liability of $1,511,139. The assumptions used in valuing the derivative liability as of June 30, 2011 were as follows:

 

Risk free interest rate

      1.8 % 

Expected life

      4.5 Years   

Dividend yield

      none   

Volatility

      100 % 

In conjunction with the financing of Ablaris during the three months ended March 31, 2011, Arrowhead sold exchange rights to certain investors whereby the investors have the right to exchange their shares of Ablaris for a prescribed number of Arrowhead shares based upon a predefined ratio. The exchange rights have a seven-year term. During the first year, the exchange right allows the holder to exchange one Ablaris share for 0.6 Arrowhead shares. This ratio declines to 0.4 in the second year, 0.3 in the third year and 0.2 in the fourth year. In the fifth year and beyond the exchange ratio is 0.1. Exchange rights for 675,000 Ablaris shares were sold during the nine months ended June 30, 2011, and remain outstanding at June 30, 2011. The exchange rights are subject to derivative accounting as prescribed under ASC 815. Accordingly, the fair value of the exchange rights on the date of issuance was estimated using an option pricing model and recorded on the Company's consolidated balance sheet as a derivative liability. The fair value of the exchange rights is estimated at the end of each reporting period and the change in the fair value of the exchange rights is recorded as a nonoperating gain or loss in the Company's consolidated statement of operations. During the nine months ended June 30, 2011, the Company recorded a gain from the change in fair value of the derivative liability of $51,690. The assumptions used in valuing the derivative liability as of June 30, 2011 were as follows:

 

Risk free interest rate

      2.5 % 

Expected life

      6.5 Years   

Dividend yield

      none   

Volatility

      100 % 

The following is a reconciliation of the derivative liability for the nine months ended June 30, 2011:

 

Value at October 1, 2010

    $ 2,408,522   

Issuance of instruments

      126,960   

Change in value

      (1,577,032 ) 

Net settlements

      —     
        

Value at June 30, 2011

    $ 958,450   
        

 

The carrying amounts of the Company's other financial instruments, which include accounts receivable and accounts payable, approximate their respective fair values due to the relatively short-term nature of these instruments.