On January 1, 20Y1 Caitlin Corporation issued $10 million in 10-year bonds. The bonds pay 7% interest annually on December 31. At issuance, the market rate of interest for bonds of comparable risk was 8% and the yield on U.S. Treasury Bonds was 3%.

1. How much cash did Caitlin receive from the bond issue? 2. How would the bond issue impact Caitlins earnings for 20Y1? Indicate the amount and circle the direction.

- Increase or Decrease?

3. Suppose that at issuance, Caitlin decided to account for the 10-year bond issue using the Fair Value Option. If the bonds were priced to yield 6% at the end of 20Y1, what entry would Caitlin have to make in order to present the appropriate fair value in the year-end 20Y1 balance sheet? Assume the change in value was due to market-wide (not firm-specific) conditions.

4. If accounting for Caitlins bonds caused pre-tax earnings to decrease by $500,000 in 20Y2, by how much did Caitlins bonds fall in price during the year? Again, assume the change in value was due to market-wide (not firm-specific) conditions.

5. Assume that Caitlin DID NOT elect to use the fair value option at issuance. Further assume that Caitlins management decides to repurchase and extinguish (retire) the bond issue on 1/1/20Y4. If the bonds are repurchased in the open market when the effective rate is 5%, how would this transaction impact Caitlins 20Y4 pre-tax earnings? Indicate the amount and circle the direction.

- Increase or decrease?

6. Caitlin wants to expand and improve several of its plant facilities. The expansion will cost $7 million and, because Caitlin is sort of cash-strapped, must be funded entirely from new debt. Caitlins CEO approaches you with a plan to finance this project by issuing $10 million in 20-year, zero-coupon bonds. Its perfect, the CEO tells you. Other companies like us are having to issue debt at a cost of 8%. With this strategy, we get plenty of cash up front and theres no earnings hit because we wont have any interest expense. Is the CEO right? Show specific calculations to support your answer