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Fees Are Us ("FAU") CDO has the following balance sheet ($ in mm)
Assets Liabilities
Treasury Bonds $100 Senior debt $188
High Yield Bonds $200 Subordinated debt $110
Equity $2
Total Assets $300 Total liabs and equity $300
Assume the following fixed interest rates on the above instruments:
Treasury bonds 2.10%
High Yield bonds 5.00%
Senior notes 2.20%
Subordinated notes 3.50%
Management fees are $3. The equity was bought exclusively by an investment banking who put FAU together and continues to manage the CDO.
a. What is the return, in dollars and percent, to the equity holders?
b. How was FAU able to "magnify" for its equity holders the return on the underlying bonds?
c. Why is the "return" to the equity holders in reality higher than the calculation in "a"?
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