A town plans to borrow about $10 million and is considering
three alternatives. A town official requests your guidance on the economic cost
of each of the arrangements and advice as to how each would affect the town’s
reported expenditures. The alternatives are:

1. The town would issue $10 million of twenty-year, 6
percent coupon bonds on September 1, 2004. The bonds would be issued at par.
The town would be required to make its first interest payment of $200,000 on
January 1, 2005.

2. The town would issue $10 million of twenty-year, 6
percent bonds on July 1, 2004. Thebonds would be sold for $9,552,293, a price
that reflects an annual yield (effective interest rate) of 6.4 percent. The
town would be required to make its first interest payment of $300,000 on
December 31, 2004.

3. The town would issue $32,071,355 of twenty-year, zero
coupon bonds on July 1, 2004. The bonds would be sold for $10 million, an
amount that reflects an annual yield of 6 percent. The bonds require no payment
of principal or interest until June 30, 2024.

1. For each of the town’s three alternatives, what would be
the town’s economic cost of using the funds in the year ending December 31,
2004? What would be the amount of interest expenditure that the town would be
required to report for the year ending December 31, 2004 in its governmental
funds?

2. Suppose that the town elects the first option and issues
$10 million of twenty-year, 6 percent coupon bonds at par on September 1, 2004.
The town establishes a debt service fund to account for resources that it sets
aside to pay principal and interest on the bonds. On December 31, 2004, the
town transfers $200,000 from the general fund to the debt service fund to cover
the first interest payment that is due on January 1, 2005.

a. How would the transfer be reported in the general fund?

b. How would the transfer be reported in the debt service
fund? What options are

available to the town to record 2004 interest in the debt
service fund?

3. Suppose that the town borrowed $10 million on September
1, 2004, and temporarily invested the proceeds in two-year, 6 percent Treasury
notes. The first payment of debt interest, $200,000, is payable on January 1,
2005.

a. What would be the town’s economic gain from investing the
funds in the year ending December 31, 2004? Ignore borrowing costs.

b. How much investment revenue should the town report for
the year ending December 31, 2004? Assume there was no change in prevailing
interest rates.