Question

What explict tax rate would keep orlando indifferent between purchasing a municipal bond with a 4.0 percent return and a taxable bond with a 5.5 percent before tax rate?

Answer 1

Orlando will be indifferent between purchasing a a municipal bond with a 4.0 percent return and a taxable bond with a 5.5 percent before tax rate when after tax return of both of them will be same.

Municipal Bond Taxable Bond

Purchase price (Assumed) $100 $100

Pre tax return $4 $5.5

Less: Tax $0 $1.5

After Tax Return $4 $4.0

Therefore, for after tax return to be same there shall be a tax levied on a certain percentage on taxable bonds.

Computation of tax rate that will make Orlando indifferent is

=Difference / Basis *100

=(5.5-4) / 5.5 *100

= 1.5 / 5.5 * 100

= 27.2727%

Therefore explicit tax rate shall be 27.2727%