Airborne Airlines Inc. has a $1,000 par value bond outstanding with 20 years to

Question

Airborne Airlines Inc. has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $102 and is currently selling for $880. Airborne is in a 30 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. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Explanation / Answer

Answer a.

Par Value = $1,000
Current Price = $880
Annual Coupon = $102
Time to Maturity = 20 years

Let annual YTM be i%

$880 = $102 * PVIFA(i%, 20) + $1,000 * PVIF(i%, 20)

Using financial calculator:
N = 20
PV = -880
PMT = 102
FV = 1000

I = 11.78%

So, yield-to-maturity on old bond issue is 11.78%

Answer b.

Pretax Cost of Debt = 11.78%

After-tax Cost of Debt = 11.78% * (1 - 0.30)
After-tax Cost of Debt = 8.25%

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