Russell Container Corporation has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $95 and is currently selling for $920 per bond. Russell Corp. is in a 25 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.
What is the cost of debt and has the aftertax cost of debt gone up or down?
(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 9.50%] |
PMT |
95 |
Yield to Maturity [YTM] |
1/Y |
? |
Time to Maturity [20 Years] |
N |
20 |
Bond Price [-$920] |
PV |
-920 |
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 = 10.47%.
Therefore, the yield to maturity (YTM) on the bond will be 10.47%”
(b)-The after-tax cost of debt
After-tax cost of debt = Yield to maturity on the bond x (1 – Tax Rate)
= 10.47% x (1 – 0.25)
= 10.47% x 0.75
= 7.85%
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