Question

Arvo Corporation is trying to choose between three alternative investments. The three securities that the company is considering are as follows: ∙ Tax-free municipal bonds with a return of 8.8%. ∙ Wooli Corporation bonds with a return of 11.75%. ∙ CFI Corp. preferred stock with a return of 9.8%. The company's tax rate is 18.00%. What is the after-tax return on the best investment alternative? Assume a 70% dividend exclusion for tax on dividends. (Round your final answer to 3 decimal places.)

Answer 1

Answer:

9.635%

Explanation:

We shall use a table to compute different values as shown below.

Investment       Return     Taxable amount    Tax Rate       After-tax return

Dividend              9.8%             30% (n1)              18%             9.2708% (w1)

Municipal bond   8.8%              0%                      18%             8.8%

Corporate bond   11.75%          100%                   18%             9.635% (w2)

The after tax return with on the best investment alternative is 9.635% for corporate bonds

Workings:

W1

9.8 *0.3*0.18 = 0.5292%

Return after tax = 9.8% -0.5292% = 9.2708%

w2

18.75*0.18 =2.115%

Return after tax = 11.75% -2.115% = 9.635%

Notes:

n1 : 70% of the dividends are excluded from taxation. Only 30% is to be taxed