Eddie Bauer Holdings (EBHI)

Market Risk—Change in Value of our Common Stock

Our Notes contain certain features that allow the holder to convert their notes into shares of our common stock upon the occurrence of certain conditions. See further discussion above under “Management’s Discussion and Analysis of Financial Condition—Sources of Liquidity” for a detailed description of the terms of conversion. The fair market value of the convertible notes is subject to market risk due to the convertible feature of the notes. The fair market value of the convertible notes will generally increase as the market price of our common stock increases and decrease as the market price falls.

As a result of the requirement that we settle any conversion of notes prior to January 3, 2009 in cash, the conversion features contained within the Notes were deemed to be an embedded derivative under SFAS 133. In accordance with SFAS 133, the embedded derivative related to the conversion features required bifurcation from the debt component of the convertible notes and a separate valuation. We recognized the embedded derivative as an asset or liability on our balance sheet and measured it at its estimated fair value, and recognized changes in its estimated fair value in other income (expense), net in the period of change. We determined the estimated fair value of the embedded derivative primarily using the Black-Scholes model and other valuation methodologies which resulted in an estimated fair value of $21.2 million as of the issuance date for the Notes. The Black-Scholes model and other valuation methodologies are complex and require significant judgments. In applying the Black-Scholes model, changes and volatility in our common stock price and the stock price of other comparable retailers and changes in risk-free interest rates could significantly affect the fair value of this derivative instrument. We estimated the fair value of the conversion features to be $1.7 million as of January 3, 2009 and accordingly recognized $9.0 million of income within other income (expense), net during fiscal 2008. Effective with the first quarter of 2009, we will no longer be required to make fair value adjustments as the conversion features of the Notes will no longer be considered an embedded derivative liability due to the fact that we will no longer be required to settle any conversion of the Notes in cash.

Market Risk—Change in Value of our Common Stock

Our Notes contain certain features that allow the holder to convert their notes into shares of our common stock upon the occurrence of certain conditions. See further discussion above under “Management’s Discussion and Analysis of Financial Condition—Sources of Liquidity” for a detailed description of the terms of conversion. The fair market value of the convertible notes is subject to market risk due to the convertible feature of the notes. The fair market value of the convertible notes will generally increase as the market price of our common stock increases and decrease as the market price falls.

As a result of the requirement that we settle any conversion of notes prior to January 3, 2009 in cash, the conversion features contained within the Notes were deemed to be an embedded derivative under SFAS 133. In accordance with SFAS 133, the embedded derivative related to the conversion features required bifurcation from the debt component of the convertible notes and a separate valuation. We recognized the embedded derivative as an asset or liability on our balance sheet and measured it at its estimated fair value, and recognized changes in its estimated fair value in other income (expense), net in the period of change. We determined the estimated fair value of the embedded derivative primarily using the Black-Scholes model and other valuation methodologies which resulted in an estimated fair value of $21.2 million as of the issuance date for the Notes. The Black-Scholes model and other valuation methodologies are complex and require significant judgments. In applying the Black-Scholes model, changes and volatility in our common stock price and the stock price of other comparable retailers and changes in risk-free interest rates could significantly affect the fair value of this derivative instrument. We estimated the fair value of the conversion features to be $1.7 million as of January 3, 2009 and accordingly recognized $9.0 million of income within other income (expense), net during fiscal 2008. Effective with the first quarter of 2009, we will no longer be required to make fair value adjustments as the conversion features of the Notes will no longer be considered an embedded derivative liability due to the fact that we will no longer be required to settle any conversion of the Notes in cash.