Assume that Jose is indifferent between investing in a corporate bond that pays 10% interest and a stock with no growth potential that pays an 8% dividend yield. Assume that the tax rate on dividends is 15%. What is Jose's marginal tax rate?

Question

Quizplus · Accepted Answer

Since Jose is indifferent between the bond paying 10% and the stock paying 8% dividend yield, we can assume that his after-tax return on the stock investment is also 10%. We know that the tax rate on dividends is 15%, which means that the pre-tax dividend yield must be 8%/(1-15%) = 9.41%. If we assume that Jose's marginal tax rate is equal to the tax rate on dividends (15%), then his after-tax return on the stock investment would be 8%*(1-15%) = 6.8%, which is lower than the 10% return on the bond investment. If we assume a higher marginal tax rate, then the after-tax return on the stock investment would be even lower. Therefore, the best assumption is that Jose's marginal tax rate is equal to the tax rate on dividends, which is 15%.

The best choice is C.

Assume That Jose Is Indifferent Between Investing in a Corporate