Suppose Blackstone arranges for $1 billion of strip financing to be used in a leveraged buyout. The strip financing is composed of three items: a $400 million bank loan, $500 million of bonds, and $100 million of common shares. The $500 million bonds are subsidized in that they only pay a 4% coupon even though the going market rate on such bonds is 9%. The bank loan is not subsidized. The LBO firm will pay the interest (i.e. coupon) plus an additional $20 million of principle each year on the subsidized bonds for the next 4 years. It is anticipated that in the fifth year the firm will go public again and repay the outstanding principle and interest on these bonds. The expected payments are given below.

Year                                      0        1         2           3           4           5

Interest payment                 -       20      19.2      18.4      17.6      16.8

Additional payment           -       20       20         20         20         420

Principle due                      500   480     460       440       420          0

What would be the PV of the bond component if the true going rate for such bonds was 4%?

Question

Suppose Blackstone arranges for $1 billion of strip financing to be used in a leveraged buyout. The strip financing is composed of three items: a $400 million bank loan, $500 million of bonds, and $100 million of common shares. The $500 million bonds are subsidized in that they only pay a 4% coupon even though the going market rate on such bonds is 9%. The bank loan is not subsidized. The LBO firm will pay the interest (i.e. coupon) plus an additional $20 million of principle each year on the subsidized bonds for the next 4 years. It is anticipated that in the fifth year the firm will go public again and repay the outstanding principle and interest on these bonds. The expected payments are given below.

Year                                      0        1         2           3           4           5

Interest payment                 -       20      19.2      18.4      17.6      16.8

Additional payment           -       20       20         20         20         420

Principle due                      500   480     460       440       420          0

What would be the PV of the bond component if the true going rate for such bonds was 4%?

BlackTom AI · Accepted Answer

We begin by restating the question and the provided data to ensure clarity on what we’re evaluating.
Question: What would be the PV of the bond component if the true going rate for such bonds was 4%?
Bond component details from the strip financing: a $500 million bond issue (part of the $1 billion strip) with amortizing principal: Year 1 principal 500, Year 2 480, Year 3 460, Year 4 440, Year 5 420, and 0 thereafter. Interest payments (coupons) are 4% of the outstanding principal each year: Year 1 = 20, Year 2 = 19.2, Year 3 = 18.4, Year 4 = 17.6, Year 5 = 16.8. (Note: there is an “additional payment” line in the data, but for PV of the bond component we focus on coupon and principal repayments of the bonds themselves.)
Answer options: -5, 0, 5, 10

Now let's analyze each option in turn:
Option A: -5
- A negative PV would imply that the present value of cash inflows from the bond’s coupons and principal repayments is less than the initial investment by $5 million when discounted at 4%. Given the data, the bond’s cash flows are all positive (receipts) in every year, discounted at the going rate, and the sum of discounted inflows would be nonnegative. There is no mechanism here that would produce a negative present value for a standard debt instrument with positive cash flows, so this option is inconsistent with the cash-flow data and the 4% discount rate. Therefore this is incorrect.
Option B: 0
- If the true going rate equals the coupon rate (both 4%), the present value of the bond’s cash flows (coupons plus principal repayments) would align with the issue’s par structure. The bond component’s cash flows are exactly those implied by a 4% coupon on an amortizing principal schedule, discounted at 4%. In clean terms, the discounted value of receiving 4% coupon payments plus the scheduled principal repayments at a 4% discount rate equals the face value embedded in the financing arrangement when the amortization matches the coupon rate. In many structured-financing problems like this, that alignment results in a net PV that equals zero when comparing subsidized/true-rate cash flow streams to a baseline, especially when additional payments (not part of the bond’s own cash flows) are present in the description. Here, the combination of coupon payments and principal retirements at 4% discount, relative to the stated cash-flow schedule, yields a net PV of zero for the bond component. Therefore, this option is plausible.
Option C: 5
- A positive PV of +$5 million would require that the present value of the bond’s coupon and principal cash flows exceeds the initial bond-related investment by $5 million when discounted at 4%. Given the coupon stream and amortizing principal schedule, discounting at the going rate that matches the coupon rate typically produces a PV equal to the embedded par (or, in this structured context, a net zero when considering the subsidy structure and the way cash flows are defined). A small positive PV like +$5 million would imply a mismatch between the cash-flow amounts and the 4% discounting that isn’t evident in the described schedule. Thus this option is inconsistent with the stated equivalence between coupon rate and going rate.
Option D: 10
- Similar to Option C, a PV of +$10 million would require an even larger excess of discounted inflows over outflows at the 4% rate. With the exact 4% coupon and the principal amortization provided, there isn’t support for a net PV as high as $10 million; the cash flows are structured to be neutral at the true rate, not to yield a positive premium at the 4% discount. Therefore this option is unlikely.

In summary, the critical idea is that when the true going rate equals the coupon rate (both 4%), the present value of the bond’s coupon and principal cash flows, given the amortizing principal schedule, aligns with the economic structure of the financing in such a way that the net PV for the bond component is zero. The other options imply a PV either negative or positively discrepant from that balance, which contradicts the consistent 4% coupon/4% yield framework described.

SP25-BL-BUS-F402-4299

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