Question

Hugh has the choice between investing in a City of Heflin bond at 6 percent or investing in a Surething bond at 9 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate, what interest rate does Surething Inc., need to offer to make Hugh indifferent between investing in the two bonds?

Answer 1

Answer:

Rate of interest = 6/60% = 10%

Explanation:

Net rate of bonds after tax will be = Rate of interest X (1 - Tax)

Heflin bond = 6% X (1 - 40%) = 3.6%

Surething Bond = 9% X (1 - 40%) = 5.4%

Since both bonds provide interest and Surething provides more than Heflin

then in order to make both incomparable Surething can decrease the rate of interest to that of Heflin so that Hugh remains indifferent will be 6%

In case there is no tax on Heflin Bond, as Hugh is in 40% marginal tax bracket, then net interest = 6 %

But for Surething Hugh will have to pay tax then after tax value of interest shall be 6% i.e. 6% = 1 - 40%

Rate of interest = 6/60% = 10%

Surething needs to pay Interest @10% on bonds. to make Hugh indifferent of both the bonds.