Airborne Airlines Inc. has a $1,000 par value bond outstanding with 15 years to

Question

Airborne Airlines Inc. has a $1,000 par value bond outstanding with 15 years to maturity. The bond carries an annual interest payment of $114 and is currently selling for $880. Airborne is in a 35 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.

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.)

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.)

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.

Explanation / Answer

Requirement a:

Computation of Yield To Maturity:

Let Yield to Maturity be x

Par Value = $1000

Years to Maturity = 15

Annual Interest = $114

Market Price = $880

(Interest * PVAF (x, 15)) + (Maturity Value * PVIF (x, 15)) = Market Price

(114 * PVAF (x, 15)) + ($1000 * PVIF (x, 15)) = $880

At x=14%, Market Price = $840.3036

At x=13%, Market Price = $896.6019

For 1% decrease in x, market price increases by $56.2659 (896.6019 - 840.336)

For how much decrease in x, market value increases by $39.664 (880 – 840.336)

Answer is 0.7049% (39.664 / 56.2659)

x = 14 – 0.7049 = 13.2951%

Yield To Maturity = 13.30%

Requirement b:

After tax cost of debt = Yield to maturity (-tax rate)

= 13.30 (1-0.35)

= 13.30 * 0.65

= 8.645%

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