Question

If the marginal tax rate (MTR) is 35%, a 3.5% annual coupon rate municipal bond will have higher after-tax cash flow than a corporate bond with which annual coupon rates (choose all that apply)?

3.5%

4%

4.5%

5%

5.5%

6%

Answer 1

Municipal bond Coupon rate - 3.5%

Tax rate on corporate bond = 35%

The Municipal Bonds are tax free but the tax has to be paid on corporate bonds, So, the return of corporate bond with tax is equivalent to municipal bond coupon rate, when

= Municipal Bond Coupon rate / ( 1 - Tax Rate )

= 3.5% / ( 1- 35%)

= 3.5% / 0.65

= 5.3846%

The Corporate Bond with coupon rate of 5.3846% is giving same return before tax compared to minicipal bonds, any coupon rate higher than 5.3846% should be accepted as it has higher returns than municipal bonds after tax.

So, 5.5% and 6% should be accepted.