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?

Question

Quizplus · Accepted Answer

Since Will's tax rate on dividends is 15%, his after-tax return on dividends will be 8% × (1 - 15%) = 6.8%. In order for Will to be indifferent between the dividend-paying stock and the corporate bond, the interest rate on the bond must also provide an after-tax return of 6.8%. Given Will's marginal tax rate of 32%, the pre-tax return on the bond that would yield 6.8% after taxes would be 10% (i.e. 10% × (1 - 32%) = 6.8%). Therefore, Choice C is the correct answer.

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