Question

What explicit tax rate would keep Orlando indifferent between purchasing a municipal bond with a 4.0 percent return and a taxable bond with a 5.5 percent before-tax return?

A. 25%
B. 27.3%
C. 31.2%
D. 33.5%
E. None of the Above

Answer 1

To determine the indifference tax rate for choosing between a municipal bond and a taxable bond, calculate the after-tax return of the taxable bond and equate it to the tax-free return of the municipal bond. Upon solving, the tax rate that makes Orlando indifferent is 27.3%%.

Step-by-step explanation:

To find the tax rate that would make Orlando indifferent between purchasing a municipal bond with a 4.0 percent return and a taxable bond with a 5.5 percent before-tax return, we need to compare the after-tax return of the taxable bond to the return of the municipal bond (which is tax-free). Let's denote the unknown tax rate as 'T'.

The after-tax return of the taxable bond can be calculated as:

(1 - T) × 5.5%

We know that Orlando would be indifferent if the after-tax return of the taxable bond equals the return of the municipal bond, so:

(1 - T) × 5.5% = 4.0%

Now, we can solve for T to find the tax rate that would make Orlando indifferent. When we do the math, we find:

T = 1 - (4.0% / 5.5%)

T = 1 - 0.727

T = 0.273, or 27.3%

Therefore, the correct answer to the question is B. 27.3%%.