Question

Suppose you want to invest $10,000. You have two options: Option #1: Invest in municipal bonds with an expected return of 8.00%, or Option #2: Invest in the corporate bonds of Jefferson & Alexander Inc. which are offering an expected return of 10.00% Assume that your decision is based solely on your tax situation. If everything else is the same for both bonds, at what tax rate would you be indifferent between these two bond investments?

Answer 1

Answer: 20%

Explanation:

Municipal Bonds are generally not taxed so if you invest in the Municipal bond, the tax rate does not affect you.

The tax rate therefore that will make you indifferent between the 2 options is the one that will take the Corporate bond returns of Jefferson to 8% so that both bonds may give you the same return after tax.

Assuming that tax rate is 'x' then,

8 = 10 (1 - x)

8 = 10 - 10x

10x = 10 - 8

10x = 2

x = 20%

At a tax rate of 20%, the Corporate bonds give an 8% return.