Accounting practices for interest expenditures may neither reflect actual economic cost nor mirror those for interest revenues.
A town plans to borrow about $10 million and is considering three alternatives. A town official request your guidance on the economic cost of each of the arrangements, and your opinion as to how they affect the town's reported expenditures:
Alternative 1: The town would issue $10 million of 20-year, 6% coupon bonds on September 1, 2013. The bonds would be issued at par. A town would be required to make it first interest payment of $300,000 on January 1, 2014.
Alternative 2: The town would issue $10 million of 20-year, 6% bonds on July 1, 2013. The bonds would be sold for $9,552,293, a price that reflects an annual yield (effective interest rate) of 6.4%. The town would be required to make its first interest payment of $300,000 on December 31, 2013.
Alternative 3: The town would issue $32,071,355 in 20-year zero coupon bonds on July 1, 2013. The bonds would be sold for $10 million, an amount that reflects an annual yield of 6%. The bonds require no payment of principal or interest until June 30, 2032.
3. Suppose that the town borrowed $10 million on September 1, 2013, and temporarily invested the proceeds in two-year, 6% Treasury notes. The first payment of interest, $300,000 is payable on January 1, 2014.
a. What would be the town's economic gain from investing the funds in the year ending December 31, 2013? Ignore borrowing cost.
b. How much investment revenue should the town report for the year ending December 31, 2013. Assume there was no change in prevailing interest rates.