An investor is in the 28 percent federal tax bracket and pays a 9 percent state tax rate and 4 percent in local income taxes. For this investor a municipal bond paying 6 percent interest is equivalent to a corporate bond paying ________ interest.

Question

Quizplus · Accepted Answer

To find the equivalent interest rate of a corporate bond, we need to use the after-tax yield formula:
after-tax yield = pre-tax yield x (1 - tax rate)
For the municipal bond, the pre-tax yield is 6 percent. But since it is tax-exempt, the after-tax yield is also 6 percent.
For the corporate bond, we need to find the pre-tax yield that, after taxes, would give us the same after-tax yield as the municipal bond.
Let x be the pre-tax yield of the corporate bond.
After federal taxes: (1 - 0.28)x
After state taxes: (1 - 0.09)(1 - 0.04)(1 - 0.28)x
After all taxes: 0.6784x
Set 0.6784x = 6 percent and solve for x:
x = 8.846 percent.
Therefore, the equivalent interest rate of the corporate bond is 8.846 percent / (1 - 0.28) = 10.17 percent.

An Investor Is in the 28 Percent Federal Tax Bracket