Question

Suppose that, holding yield constant, investors are indifferent as to whether they hold bonds issued by the federal government or bonds issued by state and local governments (that is, they consider the bonds the same with respect to default risk, information costs, and liquidity). Suppose that state governments have issued perpetuities (or consoles) with $85 coupons and that the federal government has also issued perpetuities with $85 coupons. If the state and federal perpetuities both have after-tax yields of 7%, what are their pre-tax yields? (Assume that the relevant federal income tax rate is 36.2936.29%.)

The pre-tax yield on the state perpetuity will be

The pre-tax yield on the federal perpetuity will be

Answer #1

Hence,

# - The pre-tax yeild on the state perpetuity will be 7%.

#- The pre-tax yeild on the federal perpetuity will be 10.98%.

Thankyou

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