A corporation can earn 7.5% if it invests in municipal bonds.The corporation can also earn 8.35% (before-tax)by investing in preferred stock.Assume that the two investments have equal risk.What is the break-even corporate tax rate that makes the corporation indifferent between the two investments? Assume a 70% dividend exclusion for tax on dividends.(Do not round your intermediate answer and round your final answer to two decimal places. )

Question

Quizplus · Accepted Answer

Let x be the break-even tax rate.

After-tax return of municipal bonds = 7.5% 
After-tax return of preferred stock = (1-x)(1-0.7)(8.35%) = (0.3x+0.6955)(8.35%)

At the break-even tax rate, these two returns will be equal, so we have:

7.5% = (0.3x+0.6955)(8.35%)
0.3x+0.6955 = 0.8982
x = (0.8982-0.6955)/0.3 = 0.67433, or 67.43%

However, we need to check that the result makes sense - i.e., that the preferred stock return is actually higher than the municipal bond return at this tax rate.

After-tax return of municipal bonds = 7.5% 
After-tax return of preferred stock = (1-0.67433)(1-0.7)(8.35%) = 1.09059%
Since 1.09059% > 7.5%, our result of a break-even tax rate of 67.43% is valid.

Therefore, the best choice is to invest in preferred stock if the corporate tax rate is above 33.93%.

A Corporation Can Earn 7