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. Using this information, answer the below questions.

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 is the PV of the bond component of the strip to the firm? [i.e. how much is added to equity value because of the subsidy?]

What would be the PV of the bond component if the true going rate for such bonds was 4%? [I.e. the bonds are not subsidized].