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78106_05_Web_Ch05A_p01-05

78106_05_Web_Ch05A_p01-05 - WEB EXTENSION 5A A Closer Look...

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W E B E X T E N S I O N 5A A Closer Look at Zero Coupon Bonds S ome bonds pay no interest but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income. These securities are called zero coupon bonds ( zeros ) , or original issue discount bonds (OIDs) . Some corporations use these bonds to manage their matu- rity structure. In addition, these bonds provide some desirable tax features for cor- porations, as we discuss later in this extension. Corporations first used zeros in a major way in 1981. IBM, Alcoa, JCPenney, ITT, Cities Service, GMAC, Martin-Marietta, and many other companies have used them to raise billions of dollars. Municipal governments also sell zero munis. Shortly after corporations began to issue zeros, investment bankers figured out a way to create zeros from U.S. Treasury bonds, which were issued only in coupon form. In 1983 Salomon Brothers bought $1 billion of 7%, 30-year Treasuries. Each bond had 60 coupons worth $35 each, which represented the interest payments due every 6 months. Salomon then, in effect, clipped the coupons and placed them in 60 piles; the last pile also contained the now stripped bond itself, which represented a prom- ise of $1,000 in the year 2013. These 60 piles of U.S. Treasury promises were then placed with the trust department of a bank and used as collateral for zero coupon U.S. Treasury Trust Certificates, which are, in essence, zero coupon Treasury bonds. A pension fund that, in 1984, expected to need money in 2009 could have bought 25-year certificates backed by the interest the Treasury will pay in 2009. In 1985, the Treasury Department began allowing investors to strip long-term U.S. Treasury bonds and directly register the newly created zero coupon bonds, called STRIPs, with the Treasury Department. This bypasses the role formerly played by investment banks. Now virtually all U.S. Treasury zeros are held in the form of STRIPs. These STRIPs are, of course, safer than corporate zeros, so they are very popular with pension fund managers. To understand how zeros are used and analyzed, consider the zeros to be issued by Vandenberg Corporation, a shopping center developer. Vandenberg is developing a new shopping center in San Diego, California, and it needs $50 million. The com- pany does not anticipate major cash flows from the project for about 5 years; how- ever, Pieter Vandenberg, the president, plans to sell the center once it is fully developed and rented, which should take about 5 years. Therefore, Vandenberg wants to use a financing vehicle that will not require cash outflows for 5 years. He has decided on a 5-year zero coupon bond issue, with each bond having a maturity value of $1,000. Vandenberg Corporation is an A-rated company, and A-rated zeros with 5-year maturities yield 6% at this time. (5-year coupon bonds also yield 6%.) The company is in the 40% federal-plus-state tax bracket. Pieter Vandenberg wants to know the 1
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firm s after-tax cost of debt if it uses 6%, 5-year maturity zeros, and he also wants to
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