On June l, 20Xl, a city issues $2 million in 7 percent d e m a nd bonds. Although t he bonds have a term of 10 years , they contain a " put" option permitting the holder to present the bonds for redemption, at par, any time after May 31, 20X2 . The bonds p ay interest semiannually.
1. Pre p a re journal entries to reflect how the bonds would be recorded in the city's general fund or other governmental fund for fiscal year December 31, 20Xl,
financial statementsassuming :
a. The city has entered into a qualifying take -out agree m e n t.
b. The city has not entered into a qualifying take-out agreement.
2. Suppose that on January l , 20X3, prevailing interest rates for bonds of similar credit risk had fallen to 4 percent. A bondholder needed immediate cash for personal reasons. Assuming that the bonds were publicly traded, do yo u think the bondholder would redeem his bonds? Do you think that any other bondholders would redeem their bonds? Explain.
3. Suppose, instead , that prevailing interest rates h ad increased to 9 percent. Do you think that the bondholder needing cash would redeem his bon d s? Do you think that the other bondholders would redeem their bonds?
4. Suppose that, because it is not mandate d b y the applicable GASB pronouncement, the take-out agreement does not specify the interest rate at which the financing institution would provide the funds necessary for the city to redeem its bonds. If prevailing rates h ad increased to 9 percent, at approximately what rate is it likely that the financing institution would loan the city the required funds?
5. Comment on the extent to which the demand bonds provide t h e city with one of the primary benefits of issuing long-term debt-the guarantee of a fixed interest rate over the life of the bond. To what extent does it burden the city with the corresponding disadvantage-being required to pay no less than the stated rate over the life of the bond (or otherwise r e tire the bonds at market prices)?