Assume that Lucas's marginal tax rate is 22 percent and his tax rate on dividends is 11 percent. If a dividend-paying stock (with no growth potential)pays an 9 percent dividend yield, what interest rate would a municipal bond have to offer for Lucas to be indifferent between the two investments from a cash-flow perspective?

Question

Quizplus · Accepted Answer

For Lucas to be indifferent between the two investments, the after-tax yield on the municipal bond needs to be the same as the after-tax yield on the dividend-paying stock.

First, we need to calculate the after-tax yield on the dividend-paying stock:
Dividend yield = 9%
Tax rate on dividends = 11%
After-tax dividend yield = Dividend yield * (1 - Tax rate on dividends) = 9% * (1 - 0.11) = 8.01%

Next, we need to find the interest rate on the municipal bond that would give us the same after-tax yield as the dividend-paying stock. We can use the formula:

After-tax yield on municipal bond = Interest rate on municipal bond * (1 - Marginal tax rate)

Solving for the interest rate on the municipal bond:

Interest rate on municipal bond = After-tax yield on dividend-paying stock / (1 - Marginal tax rate)
= 8.01% / (1 - 0.22)
= 10.29%

Therefore, the municipal bond would need to offer an interest rate of 10.29% for Lucas to be indifferent between the two investments. Since D is the closest option, it is the best choice.

Assume That Lucas's Marginal Tax Rate Is 22 Percent and His