Question

A taxable issue yields 5.4 percent, and a similar municipal issue yields 3.9 percent. What is the critical marginal tax rate? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

We know that Municipal bonds are tax free bonds and company is not required to pay tax on its cost.

So in such scenario, after-tax cost of debt of a bond equals to yield on a similar municipal bonds.

here yield on municipal bond = 3.9%

yield on taxable bond = 5.4%

let tax rate be T

=> after-tax yield on taxable bond = 5.4*(1-T)

when we equal it to municipal bond yield, we get

=> 5.4*(1-T) = 3.9

=> T = (5.4 - 3.9)/5.4 = 27.78%

So, Marginat tax rate T = 27.78%