Assume that Juanita is indifferent between investing in a corporate bond that pays 10.20 percent interest and a stock with no growth potential that pays a 6 percent dividend yield. Assume that the tax rate on dividends is 15 percent. What is Juanita's marginal tax rate?
A)50 percent
B)40 percent
C)30 percent
D)15 percent
E)None of the choices are correct.

Question

Quizplus · Accepted Answer

Juanita is indifferent between a 10.20% interest from a bond and a 6% dividend yield after tax. The after-tax yield on the dividend is 6% because dividends are taxed at 15%, meaning she keeps 85% of the dividend yield. To find the equivalent pre-tax yield on the dividend that matches the bond's interest rate, we set up the equation: 0.85 * Pre-tax yield = 6%. Solving for the pre-tax yield gives us 7.0588%. This means that if Juanita were taxed at her marginal rate on a 7.0588% yield, she would receive the same after-tax income as from the 6% dividend yield. Since the bond pays 10.20% and is equivalent in after-tax terms to a 7.0588% yield, her marginal tax rate must be such that 10.20% after tax is equivalent to a 7.0588% yield. The marginal tax rate that equates these two yields is 50%, as it reduces the 10.20% to 7.0588% after tax.

Assume That Juanita Is Indifferent Between Investing in a Corporate