Question

A 5-year corporate bond yields 7.0%. A 5-year municipal bond (tax exempt bond) of equal risk yields 5.0%. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds?

Answer 1

The tax rate is approximately(rounded to a whole) 29%

Step-by-step explanation:

The federal tax that would make an investor indifferent between the 5-year corporate bond and the 5-year municipal bond can be derived by equating the return on the former to the taxable return of the latter as below:

5%=7%*(1-t)

where the t is the unknown tax rate

Note that the return on 5-year corporate bond is taxable while the return on the municipal bond is tax-free

5%=7%*(1-t)

5%/7%=1-t

0.7143 =1-t

t=1-0.7143

t=29%