Question

A municipal bond is paying a 6 percent annual yield. An equivalent risk corporate bond is paying 7 percent. Investors with a tax rate of ________ or higher would prefer the municipal bond.

Answer 1

Answer:

14.29% or higher

Explanation:

Municipal bonds interest rates are tax free. Corporate bond rates however are have tac benefits through tax shield.

The formula for aftertax corporate bond rate = pretax rate(1-tax)

pretax rate = 7% or 0.07 as a decimal

aftertax rate(to be indifferent between the two) = 6% or 0.6

In order to be indifferent, the tax rate would be;

0.07 ( 1- tax ) = 0.06

0.07 - 0.07tax = 0.06

0.07 - 0.06 = 0.07tax

0.01 / 0.07 = tax

tax = 0.1429 or 14.29%

Therefore, Investors with a tax rate of 14.29% or higher would prefer the municipal bond.