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

Question

Quizplus · Accepted Answer

To calculate the break-even corporate tax rate, we need to set the two investment options equal and solve for the tax rate.

0.075 = (1 - t) * 0.085
0.075 = 0.085 - 0.085t
0.01 = 0.085t
t = 0.01 / 0.085
t = 0.1176 or 11.76%

However, this is the before-tax break-even point. To find the after-tax break-even point, we need to calculate the tax-adjusted return of the preferred stock investment:

0.085 * (1 - t) = 0.075
0.085 - 0.085t = 0.075
0.01 = 0.085t
t = 0.01 / 0.085
t = 0.1176 or 11.76%

Now we can see that the break-even corporate tax rate is 11.76%, which is equivalent to an effective tax rate of 39.22% (1 - 0.1176) due to the double taxation of corporate profits. Therefore, if the corporate tax rate is expected to be greater than 39.22%, investing in municipal bonds is a better option to maximize the return on investment.

A Corporation Can Earn 7