Question

A 5-year corporate bond yields 10.70%. A 5-year municipal bond of equal risk yields 6.50%. 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.)

Answer 1

To determine the federal tax rate at which you would be indifferent between the two bonds, subtract the federal tax rate from the pre-tax yield of the corporate bond and set it equal to the pre-tax yield of the municipal bond.

Step-by-step explanation:

To determine the federal tax rate at which you would be indifferent between the two bonds, we need to calculate the after-tax yields of each bond. Since the state tax rate is zero, the after-tax yield of the municipal bond is simply its pre-tax yield of 6.50%. For the corporate bond, we need to subtract the federal tax rate from the pre-tax yield to get the after-tax yield. Let's call the federal tax rate 'r'. The after-tax yield of the corporate bond is then 10.70% - r.

Since you are indifferent between the two bonds, their after-tax yields must be equal. Therefore, we can set up the following equation:

6.50% = 10.70% - r

Solving for 'r', we find that the federal tax rate at which you would be indifferent between the two bonds is 4.20%.

Answer 2

The multiple choices are as follows:

a.

25.40%

b.

29.03%

c.

39.25%

d.

33.98%

e.

27.38%

The correct option is C,39.25% federal tax rate

Step-by-step explanation:

In determining the federal tax that one would be indifferent in choosing between the two bonds, we equate the yield of the two bonds as follows with tax element being deducted from corporate bond yield:

6.50%=10.70%*(1-t)

The t is the tax rate which is the unknown

divide both sides by 10.70%

6.50%/10.70%=1-t

0.607476636 =1-t

t=1-0.607476636

t=0.392523364 =39.25%