Suppose that your marginal federal income tax rate is 30%,the sum of your marginal state and local tax rates is 5%,and the yield on thirty-year U.S.Treasury bonds is 10%.You would be indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond issued within your state (ignoring differences in liquidity,risk,and costs of information)if the municipal bond has a yield of
A) 6.5%.
B) 7.0%.
C) 9.5%.
D) 10.0%.

Question

Quizplus · Accepted Answer

To be indifferent between buying a thirty-year Treasury bond and a thirty-year municipal bond, the after-tax yield on the municipal bond must be equal to the yield on the Treasury bond.

After taxes, the yield on the Treasury bond would be (1 - 0.30) x 10% = 7%.

To determine the yield on the municipal bond that would make you indifferent, you need to adjust for the state and local tax rates.

The pre-tax yield required would be:

(1 + 0.05) x yield on municipal bond = 10%

Yield on municipal bond = 10% / 1.05 = 9.52%

After-tax yield on the municipal bond would be (1 - 0.30) x 9.52% = 6.66%

Since the after-tax yield on the municipal bond is lower than the after-tax yield on the Treasury bond, you would not be indifferent.

Therefore, the highest yield option that would make you indifferent is 7.0%, which is the answer choice B.

Suppose That Your Marginal Federal Income Tax Rate Is 30%,the