Question

A 5-year corporate bond yields 10.90%. A 5-year municipal bond of equal risk yields 6.30%. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds? (Round your final answer to two decimal places.)

a. 57.80% b. 42.20% c. 46.00% d. 17.20% e. 73.02%

Answer 1

To find the federal tax rate at which you are indifferent between the two bonds, subtract the municipal bond yield from the bond yield to get the taxable yield. Then, divide the taxable yield by (1 - Tax Rate) to find the after-tax yield.

Step-by-step explanation:

To find the federal tax rate at which you are indifferent between the two bonds, you need to consider the after-tax yield. The after-tax yield is calculated by subtracting the tax owed from the bond yield. Let's assume the bond yield is 10.90% and the municipal bond yield after-tax is 6.30%. To calculate the taxable yield, subtract the municipal bond yield from the bond yield:

Taxable Yield = Bond Yield - Municipal Bond Yield

Taxable Yield = 10.90% - 6.30% = 4.60%

Next, divide the taxable yield by (1 - Tax Rate) to find the after-tax yield:

After-Tax Yield = Taxable Yield / (1 - Tax Rate)

Now you can set up the equation:

4.60% = 6.30% / (1 - Tax Rate)

Solving for Tax Rate:

Tax Rate = (1 - 6.30% / 4.60%) ≈ 42.20%

Therefore, you would be indifferent between the two bonds at a federal tax rate of approximately 42.20%.