Question

answer for part a, and b

Suppose the interest rate on a taxable corporate bond is 4 percent while a municipal, tax exempt bond has an interest rate of 3 percent, and they are similar in every other way.

a. Assuming the income tax rate is 30 percent, calculate the after tax interest rate on the corporate bond. Is it higher or lower than the after tax return on the municipal bond?

b. What is the income tax rate that equalizes the after tax return between the corporate bond and the municipal bond.

Answer 1

SOLUTION:-

a. After tax interest rate of cororate Bond = Interest rate on corporate bond * (1 - Income Tax)

After tax interest rate of corporate Bond = 4% * (1 - 0.30)

After tax interest rate of corporate Bond = 2.80%

The return on corporate bond is lower than return on municipal bond

b. After tax interest rate of corporate Bond = Interest rate on corporate bond * (1 - Income Tax)

3% = 4% * (1 - Income tax)

Income tax = 25%

At 25% Income tax the tax return from corporate bond and the municipal bond are equal.

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