Question

Russell Container Corporation has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $119 and is currently selling for $940 per bond. Russell Corp. is in a 40 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.)
  

Answer 1

Answer a.

Face Value = $1,000
Current Price = $940
Annual Coupon = $119
Time to Maturity = 20 years

Let Annual YTM be i%

$940 = $119 * PVIFA(i%, 20) + $1,000 * PVIF(i%, 20)

Using financial calculator:
N = 20
PV = -940
PMT = 119
FV = 1000

I = 12.74%

Annual YTM = 12.74%

Answer b.

Before-tax Cost of Debt = 12.74%

After-tax Cost of Debt = 12.74% * (1 - 0.40)
After-tax Cost of Debt = 7.64%