Assume that Will's marginal tax rate is 32% and his tax rate on dividends is 15%.If a dividend-paying stock (with no growth potential)pays a dividend yield of 8%,what interest rate must the corporate bond offer for Will to be indifferent between the two investments from a cash-flow perspective?

Question

Quizplus · Accepted Answer

The after-tax rate of return on the dividend-paying stock can be calculated as follows:
Dividend yield = 8%
Tax rate on dividends = 15%
After-tax dividend yield = 8% x (1-0.15) = 6.8%
The after-tax rate of return on the corporate bond can be calculated as:
Before-tax interest rate = after-tax interest rate / (1-0.32) = after-tax interest rate / 0.68
To be indifferent between the two investments, Will must earn the same after-tax rate of return on both investments. Therefore:
Before-tax interest rate on the corporate bond = after-tax dividend yield on the stock
Before-tax interest rate on the corporate bond = 6.8% / 0.68 = 10%
Therefore, the corporate bond must offer an interest rate of 10% for Will to be indifferent between the two investments from a cash-flow perspective.

Assume That Will's Marginal Tax Rate Is 32% and His