Assume that Keisha's marginal tax rate is 40% and her tax rate on dividends is 15%. If a city of Atlanta bond pays 7.65% interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Keisha to be indifferent between the two investments?

Question

Quizplus · Accepted Answer

Since Keisha's marginal tax rate is 40%, she will pay 40% tax on the interest earned from the bond. Hence, her after-tax return from the bond will be 7.65%*(1-40%)=4.59%. On the other hand, since her tax rate on dividends is only 15%, she will pay only 15% tax on the dividends earned from the stock. To be indifferent between the two investments, the dividend yield on the stock should be such that her after-tax return from the stock is also 4.59%. Therefore, dividend yield=4.59%/(1-15%)=5.4%. Since a stock with no growth potential is expected to pay out its entire earnings as dividends, the dividend yield equals the earnings yield. Hence, the stock should offer an earnings yield of 5.4%, which is closest to option C, 9%. Option C is, therefore, the correct answer.

Assume That Keisha's Marginal Tax Rate Is 40% and Her