Question

An investor is in the 28 percent federal tax bracket. For this investor, a municipal bond paying 4 percent interest is equivalent to a corporate bond paying ________ interest.

Answer 1

Assuming municipal bonds are tax free

Interest on corporate bonds are taxable

Hence to earn a required rate of interest of 4% corporate tax bond should provide a post tax rate of interest of 4%

Hence after tax rate of return required from corporate bonds=4%

or pre tax rate of return *(1- tax rate)=4%

or pre tax rate of return*(1-28%)=4%

or pre tax rate of return =4%/72%= 5.5556%

An investor is in the 28 percent federal tax bracket. For this investor, a municipal bond paying 4 percent interest is equivalent to a corporate bond paying 5.5556% interest.