Question

Hugh has the choice between investing in a City of Heflin bond at 6 percent or a Surething bond. Assuming that both bonds have the same nontax characteristics and that Hugh has a 35 percent marginal tax rate. What interest rate does Surething, Inc. need to offer to make Hugh indifferent between investing in the two bonds?

Answer 1

City of Heflin bond is a tax exempt bond. The both after tax and pre tax rate on the bond is equal . The rate of 6% will be same both in after tax and pre tax situation.

Surething Inc. bond will be taxable , the after tax and pre tax rates will be different .

To be indifferent between investing in the two bonds , Surething Inc. must provide the same after tax return as the City of Heflin bond is giving , 6% . We will solve for the required pre tax rate of return Surething should provide to Hugh.

After tax return = Pre tax * (1 - Marginal Tax rate )

6% = Pre tax * ( 1 - 0.35)

Pre tax return = 6 / (1-0.35)

Pre tax return = 6 / 0.65 = 9.23%

Surething Inc. must offer an interest rate of 9.23% , to generate a 6% after tax return and by doing so make Hugh indifferent between investing in the two bonds.