Question

Melinda invests $200,000 in a City of Heflin bond that pays 6% interest. Alternatively, Melinda could have invested the $200,000 in a bond recently issued by Surething, Inc., that pays 8% interest with similar risk and other non tax characteristics to the City of Heflin bond. Assume Melinda's marginal tax rate is 25%.
A. What is her after-tax rate of return for the City of Heflin bond?
B. How much explicit tax does Melinda pay on the City of Heflin bond?
C. How much implicit tax does she pay on the City of Heflin bond?
D. How much explicit tax would she have paid on the Surething, Inc.,bond?
E. What is her after-tax rate of return on the Surething, Inc., bond?

Answer 1

Answer and Explanation:

a.

Her after-tax rate of return for theCity of Heflin bond will be 6% since the City of Heflin bond is a tax exempt bond which is why Melinda’s after tax rate of return on the bond is equal to its pretax rate of return (6 percent).

b.

Melinda pay no explicit tax on the City of Heflin bond because the City of Heflin bond is a tax exempt bond which was the reason why Melinda pays no explicit tax on the interest earned from the City of Heflin bond

c.

Melinda earns $12,000 of interest on the City of Heflin bond (i.e., 6% x $200,000). A similar priced taxable bond (i.e., the Surething, Inc. bond) which would pay $16,000 of taxable interest (i.e., 8% x $200,000). Melinda pays $4,000 of implicit tax on the City of Heflin bond (i.e., the difference between the pretax interest earned from a similar taxable bond ($16,000) and the pretax interest earned from the City of Heflin bond ($12,000).

d. Therefore since Melinda’s marginal tax rate is 25 percent, she would have paid $4,000 of explicit tax which is 25% x $16,000 on the interest earned from the Surething, Inc. bond

e. Melinda after-tax income from the Surething, Inc. bond would be $12,000 which is ($16,000 interest income - $4,000 tax). hence, her after-tax return from the Surething, Inc. bond would be 6 percent (after-tax income of $12,000 divided by her $200,000 investment)

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