Question

Hugh has the choice between investing in a City of Heflin bond at 7.2 percent or investing in a Surething bond at 10.2 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate, in which bond should he invest? Hugh should invest in the

Answer 1

Calculate the after tax returns on City of Heflin Bond:

Since City of Heflin bond has tax exemption, income tax will be 0 and before tax return on City Bond will be 7.2%. (Given in the question).

Therefore,

After tax return on city bond of Heflin = 7.2% only as per the below formula:

After tax return on city bond = Before tax return on city bond - Income tax

= 7.2% - 0%

= 7.2%.

Now, calculate the after tax returns on Surething Bond:

Surething bond has 40% Marginal Tax and before tax return on it is 10.2%. (Given in the question).

After tax return on Surething bond = Before tax return - Income tax

= 10.20% - (10.20% * 40%)

= 10.20% - 4.08%

= 6.12% or 0.0612

Since the after tax return of Heflin bond (7.2%) is higher than the after tax return of Surething (6.12%), Hugh should choose to invest in City of Heflin bond only.

Interest Rate:

After tax return = Pretax return * (1 - tax rate)

0.033 = x*(1 - 0.40)

0.033 = 0.60x

x = 0.033/0.60

x = 0.055

x = 5.5%

Therefore, interest rate is 5.5%.