Question

1. Suppose there are two types of investors in the municipal bond market. The interest on municipal bonds is tax free. 40% of the participants pay a 30% tax rate and 60% pay a 15% tax rate. Consider the following bond:

Price of bond = $1000

Interest payment on bond = $40

Interest payment on a similar bond with the same price that is not tax free = $55

1. (10 points) Which, if any, type of investor should choose the municipal bond over the taxable bond? Explain.
2. (10 points) Given your answer in part a, what would you expect would happen to the price of the bond?

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

A. Interest payment on similar taxable bond (C)= $55

NET COUPON FOR:
a. 15% tax rate participants:
=C*(1-t)
=55*(1-0.15)
= $46.75

15% tax rate participants will choose TAXABLE BOND.

b. 30% tax rate participants:
=C*(1-t)
=55*(1-0.30)
= $38.5

30% tax rate participants will choose MUNICIPAL BOND.

b. The price of the municipal bond will decrease as there will be less demand for it by 60% of participants.

The price of Similar taxable bond will increase, as the demand will shift here.