Question 3: Goldman Sachs issued 20 year (plain vanilla) zero coupon bonds in Au

Question

Question 3: Goldman Sachs issued 20 year (plain vanilla) zero coupon bonds in August 2005 to finance an investment project. Assume that Goldman's bonds were default free at the time and that the yield to maturity was 4%. The promised repayment amount was $350 million, due in August 2025. It is now August 2011 a. How much money did the company raise? b. What is the yield to maturity and the market value of the bonds? Give two important reasons why the value of the bonds has changed since they were issued. For this problem assume that the current treasury strip price of $1 dollar to be received in August 2025 is $0.44. Also assume that Morgan Stanley currently has a very similar default risk to that of Goldman Sachs. Morgan Stanly's zero coupon bonds due in August 2025 are currently trading at 30 cents on the dollar c. The project which the bonds financed has done very well, and the company has a large cash surplus. Goldman's CFO is considering buying back the bonds now. The CFO says that the only reason for the repurchase is: "If we buy the bonds now, our cash outlay will be lower than if we wait until maturity to pay the bondholders." Is he correct? Would repaying now create value for the company? Explain.

Explanation / Answer

1)In 2005 the amount of money the company raised can be found using PV. Put the following inputs in your financial calculator:

FV=$ 350 million

PMT=0

n=20

I/Y=4

Therefore, PV $ 159.74. Therefore in 2005 the company raised $ 159.74 million.

2) Since Goldman Sachs has similar risk to Morgan Stanley we should use discount rate (YTM) from Morgan Stanley bonds.

I/Y for Morgan Stanley bonds:

FV=1

PMT=0

N=14

PV=0.30

Therefore, I/Y= 8.98% which the yield to maturity of Goldman Sachs bond as well.

Thus, current market price (PV )of Goldman Sachs bond:

FV=350

PMT=0

n=20

I/Y=8.98            

Therefore, PV= $ 105.01

The reason why the yield of the bond has changed is because:

3) Yes it would create value as the value of the bonds have decreased. If yield would have been 4 % the bonds would be valued at $ 202.12. But with yields at 8.98% the bonds are valued at $ 105.01. A big assumption is that Goldman Sachs is not planning to re finance its debt. Cost of refinancing would be higher since yields have gone up.

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