Question

Suppose the rate on a corporate bond is 5%. Your marginal tax rate is 10%. What is the equivalent tax-free rate of this corporate bond? A. 5% B. 15% C. 4.5% D. 4% E. 3.36%

Answer 1

The equivalent tax-free rate of a corporate bond with a 5% rate for an individual in a 10% marginal tax bracket is 4.5%.

Step-by-step explanation:

The question involves calculating the equivalent tax-free rate of a corporate bond for a person with a 10% marginal tax rate. To find this rate, we need to adjust the corporate bond rate by factoring in the taxation. The formula to convert a taxable interest rate to a tax-free rate is: tax-free rate = taxable rate × (1 - marginal tax rate).

In this case, the taxable rate on the corporate bond is 5%, and the marginal tax rate is 10%. So the equivalent tax-free rate would be calculated as follows:

tax-free rate = 5% × (1 - 0.10) = 5% × 0.9 = 4.5%

Therefore, the correct answer is C. 4.5%.

Answer 2

To calculate the equivalent tax-free rate of a corporate bond, we need to adjust the bond's stated rate by taking into account your marginal tax rate. Here's how we can calculate it:

1. Stated rate on the corporate bond: 5%

This is the rate mentioned on the bond.

2. Marginal tax rate: 10%

Your marginal tax rate represents the portion of your income that you pay in taxes.

To find the equivalent tax-free rate, we need to adjust the bond's stated rate by subtracting the tax savings from the interest earned.

Formula: Equivalent Tax-Free Rate = Stated Rate × (1 - Marginal Tax Rate)

Using the values provided:

Equivalent Tax-Free Rate = 5% × (1 - 10%) = 5% × (1 - 0.1) = 5% × 0.9 = 0.045 = 4.5%

Therefore, the equivalent tax-free rate of the corporate bond is 4.5%, which corresponds to option C.