Airborne Airlines Inc. has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $106 and is currently selling for $860. Airborne 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.

7.52%

Explanation:

First and foremost, the yield to maturity on the old issue is computed using the rate formula in excel as calculated below:

=rate (nper, pmt,-pv, fv)

the nper is the number of times the bond would pay annual coupon interest of $106, which is 20 times

pmt is the amount of annual coupon payment which is $106

pv is the current price of the bond at $860

fv is the face value of the bond at $1000

=rate (20,106,-860,1000) = 12.54%

The yield to maturity on the new issue is 12.54% as well

after-tax cost of debt=pretax cost of debt * (1-t)

pretax cost of debt is yield to maturity of 12.54%

t is the tax rate of 40% or 0.4

after-tax cost of debt=12.54% * (1-0.4) = 7.52%