Assume that Lucas's marginal tax rate is 12 percent and his tax rate on dividends is 6 percent. If a dividend-paying stock (with no growth potential)pays an 8 percent dividend yield, what interest rate would a municipal bond have to offer for Lucas to be indifferent between the two investments from a cash-flow perspective?

Question

Quizplus · Accepted Answer

Lucas's after-tax rate of return on the dividend-paying stock would be:
0.08(1-0.06) = 0.0752 or 7.52%
Therefore, to be indifferent between the stock and a municipal bond, the rate of return on the bond would have to be 7.52%. Since Lucas's marginal tax rate is 12%, he would pay more in taxes on the interest income from the bond than on the dividend income from the stock. So, the bond would have to offer a higher pre-tax rate of return than the stock's dividend yield. Hence, the answer is 7.52 percent.

Assume That Lucas's Marginal Tax Rate Is 12 Percent and His