Question

Suppose you want to invest $10,000. You have two options: (1) Invest in California municipal bonds with an expected rate of return of 13.00%, or (2) invest in J and K Corp.’s bonds with an expected rate of return of 19.50%. Assume that your decision is based on a tax perspective. If everything else is the same for both bonds, at what tax rate would you be indifferent between these two bonds?

Answer 1

To determine the tax rate at which you would be indifferent between investing in California municipal bonds and J and K Corp.'s bonds, calculate the after-tax returns of both options.

Step-by-step explanation:

To determine the tax rate at which you would be indifferent between investing in California municipal bonds and J and K Corp.'s bonds, you need to calculate the after-tax returns of both options.

Let's assume the tax rate is 'x'. For the California municipal bonds, the after-tax return would be 13.00% × (1 - x) = 0.13 × (1 - x). For J and K Corp.'s bonds, the after-tax return would be 19.50% × (1 - x) = 0.195 × (1 - x).

Set these two expressions equal to each other and solve for 'x':
0.13 × (1 - x) = 0.195 × (1 - x).

After solving this equation, the tax rate at which you would be indifferent between the two bonds is approximately 0.354, or 35.4%.

Answer 2

a tax-rate for 33.33% will make both investment yield an equal return after-taxes

Step-by-step explanation:

the municipal bonds aare tax free, while the J and K Corp.'s bond are subject to tax income.

threfore to be indifferent between these bonsd the tax rate will equal the corp bon rate after taxes with the municipal bond:

pretax x (1 - t ) = after tax

0.195 x (1-t) = 0.13

1 - 0.13/0.195 = t

t = 1/3 = 33.33%