Final answer:
To be indifferent between a dividend-paying stock with an 8% yield (taxed at 15%) and a municipal bond, the bond must offer the same after-tax yield. After tax, the dividend yield is 6.8%. Therefore the municipal bond must have a 6.8% interest rate for Lucas to be indifferent.
Step-by-step explanation:
To determine the interest rate a municipal bond would need to offer for Lucas to be indifferent between the dividend-paying stock and the bond, we need to account for the different tax rates on dividend income and municipal bond interest. Since Lucas' marginal tax rate is 30%, but his tax rate on dividends is only 15%, he will keep more of the dividends he receives compared to regular income.
The stock pays an 8% dividend yield, so after taxes, Lucas would keep 85% of that yield (100% - 15%). Therefore, his after-tax yield on the stock would be 8% * 0.85 = 6.8%. Municipal bond interest is typically exempt from federal taxes, so Lucas would not pay any taxes on the bond's interest. For him to be indifferent, the bond would need to offer the same after-tax yield as the stock, which is 6.8%.
The correct answer is D. 6.8%.In order for Lucas to be indifferent between the dividend-paying stock and a municipal bond, the interest rate on the municipal bond would have to match the after-tax yield of the stock. The after-tax yield of the stock can be calculated by multiplying the dividend yield by (1 - tax rate on dividends). So, the after-tax yield of the stock is 8% * (1 - 0.15) = 6.8%. Therefore, the interest rate on the municipal bond would have to be 6.8% for Lucas to be indifferent between the two investments from a cash-flow perspective.