A corporation can earn 7.5% if it invests in municipal bonds.The corporation can also earn 8.5% (before-tax)by investing in preferred stock.Assume that the two investments have equal risk.What is the break-even corporate tax rate that makes the corporation indifferent between the two investments?

Question

Quizplus · Accepted Answer

Let T be the corporate tax rate.
After-tax rate of return from municipal bond = 7.5%
After-tax rate of return from preferred stock = (1-T)(8.5%)
For the corporation to be indifferent,
(1-T)(8.5%) = 7.5%
Solving for T, we get T = 1- (7.5%/8.5%) = 0.1176 or 11.76%
To find the break-even tax rate, we need to convert this into a percentage, which is 11.76% x 100 = 39.22%
Therefore, the corporation is indifferent between the two investments if the tax rate is 39.22% or higher. 
Thus, the best choice is C.

A Corporation Can Earn 7