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Bond Valuation, Yield to Maturity and the After Tax Cost of Debt

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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.

a. Compute the approximate yield to maturity on the old issue and use this as the yield for the new issue.
b. Make the appropriate tax adjustment to determine the aftertax cost of debt.

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Solution Preview

See the attached file for complete solution. The text here may not be copied exactly as some of the symbols / tables may not print. Thanks

To calculate yield to maturity on old issue, remember the following equation

PV(bond) = PV(coupon payments) + PV(final payment)
The YTM is calculated by hit and trial method. Use an initial value of YTM and see if the RHS is greater than or less than 920. If it is greater than increase the value of YTM else decrease and recalculate.

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Solution Summary

The posting explains how to calculate the yield to maturity on a bond given coupon rate, current market price and par value. The YTM is used to calculate the after tax cost of the debt. This solution is included both in plain text and calculations are shown in excel.