A corporation can earn 7.50% if it invests in municipal bonds.The corporation can also earn 8.15% (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 50.00% 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 T be the corporate tax rate.

After-tax yield from the municipal bonds investment = 7.50%

After-tax yield from the preferred stock investment = (1 - T) x 8.15% x (1 - 0.50) + 0.50 x 8.15% = (1 - T) x 4.075% + 4.075%

The corporation is indifferent between the two investments when the after-tax yields are equal.

So, we need to solve the following equation for T:

7.50% = (1 - T) x 4.075% + 4.075%

Simplifying, we get:

T = 15.95%

Therefore, the break-even corporate tax rate that makes the corporation indifferent between the two investments is 15.95%.

Since this is less than the current corporate tax rate of 21%, the corporation should invest in municipal bonds.

A Corporation Can Earn 7