Assume that John's marginal tax rate is 40%.If a city of Austin bond pays 6% interest,what interest rate would a corporate bond have to offer for John to be indifferent between the two bonds?

Question

Quizplus · Accepted Answer

John's after-tax rate of return from the city of Austin bond would be (1-0.40) x 6% = 3.6%. Therefore, for him to be indifferent between the two bonds, the corporate bond would have to offer an interest rate of 3.6% / (1-0.40) = 6%. However, since the corporate bond interest is taxable, John's after-tax return would be (1-0.40) x corporate bond interest rate. Therefore, setting this equal to the after-tax return from the city of Austin bond, we get:

(1-0.40) x corporate bond interest rate = 3.6%
corporate bond interest rate = 3.6% / (1-0.40) = 6.00%

Since the corporate bond would have to offer a higher interest rate than the city of Austin bond to compensate for the higher tax liability, the only answer that makes sense is B) 10.00%.

Assume That John's Marginal Tax Rate Is 40