Assume that Lucas' marginal tax rate is 30% and his tax rate on dividends is 15%. If a dividend-paying stock (with no growth potential) pays an 8% dividend yield, what interest rate would a municipal bond have to offer for Lucas to be indifferent between the two investments?

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Quizplus · Accepted Answer

Since Lucas' tax rate on dividends is 15%, his after-tax dividend yield is 8% * (1 - 0.15) = 6.8%. For Lucas to be indifferent between the dividend-paying stock and the municipal bond, the bond would have to offer a yield that is also 6.8% (or higher) after taxes. Lucas' marginal tax rate is 30%, so he would save 30% in taxes on the interest income from the municipal bond. Therefore, the taxable yield of the bond needs to be 6.8% / (1 - 0.3) = 9.71%. Since municipal bonds typically offer a lower yield than corporate bonds due to their tax-exempt status, it is likely that Lucas would not be able to find a municipal bond that offers a 9.71% yield, making the dividend-paying stock the best choice for him.

Assume That Lucas' Marginal Tax Rate Is 30% and His