Question

Assume that Will's marginal tax rate is 40 percent and his tax rate on dividends is 15 percent. If a dividend-paying stock (with no growth potential) pays a dividend yield of 7.2 percent, what interest rate must the corporate bond offer for Will to be indifferent between the two investments from a cash-flow perspective?

Answer 1

For Will to be indifferent between the two investments from the cash flow perspective, the after tax dividend yield must be equal to the after-tax yield on the corporate bond

The before tax dividend yield * (1 - dividend tax rate) = Before-tax yield on the corporate bond * (1 - marginal tax rate)

0.072 * (1 - 0.15) = Before-tax yield on the corporate bond * (1 - 0.40)

0.0612 = Before-tax yield on the corporate bond * 0.60

Before-tax yield on the corporate bond = 0.0612/0.60

Before-tax yield on the corporate bond = 0.102

Before-tax yield on the corporate bond = 10.2%