Question

Hugh has the choice between investing in a City of Heflin bond at 5.70 percent or a Surething bond at 9.25 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate. What interest rate does Surething Inc., need to offer to make Hugh indifferent between investing in the two bonds? (Round your answer to 2 decimal places.) What is the interest rate?

Answer 1

Ans-Hugh will pay tax on its interest income and hence the after tax rate of income shall be= Interest rate * (1-tax)

City of Heflin bond is offering a rate of 5.70 % after tax rate of return, hence Surething should offer a interests rate that given Hugh after tax rate of 5.70%.

Tax rate is given 40%= 0.40

So

Interest rate * (1-tax) = 5.70%

Interest rate * (1-0.40)=0.057

Interest rate *0.60=0.057

Interest rate= 0.057/0.60

Interest rate = 0.095= 9.5%

Hence Sutething should offer 9.5% intrests rate.

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