Question

Airborne Airlines Inc. has a $1,000 par value bond outstanding with 30 years to maturity. The bond carries an annual interest payment of $108 and is currently selling for $850. Airborne is in a 20 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

a. Compute the yield to maturity on the old issue and use this as the yield for the new issue. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

b. Make the appropriate tax adjustment to determine the aftertax cost of debt.

Answer 1

(a)-The yield to maturity on the old issue and use this as the yield for the new issue.

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 10.80%]	PMT	108
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [30 Years]	N	30
Bond Price [-$850]	PV	-850

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 12.77%

Therefore, the yield to maturity (YTM) on the bond will be 12.77%”

(b)-The after-tax cost of debt

After-tax cost of debt = Yield to maturity on the bond x (1 – Tax Rate)

= 12.77% x (1 – 0.20)

= 12.77% x 0.80

= 10.22%