Question

A corporation can earn 7.5% if it invests in municipal bonds. The corporation can also earn 8.40% (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate that makes the corporation indifferent between the two investments?

Answer 1

Answer:

A tax rate of 10.71% should make both both indifferent for investors.

Explanation:

the municipal bonds are income-tax free so we should solve for the tax rate which makes both bonds equaly attractive.

0.075 = after-tax rate

0.084 = pre-tax rate

$pre-tax (1- t) = after-tax\\0.084 (1-t) = 0.075\\1 - t = 0.075 \div 0.084\\t = 1 - 0.075 \div 0.084\\t = 0.10714285$

A tax rate of 10.71% should make both both indifferent for investors.