Question

9. Melinda invests $200,000 in a City of Heflin bond that pays 6 percent interest. Alternatively, Melinda could have invested the $200,000 in a bond recently issued by Surething Inc., that pays 8 percent interest and has risk and other nontax characteristics similar to the City of Heflin bond. Assume Melinda’s marginal tax rate is 25 percent. (Leave no cells blank - be sure to enter "0" wherever required.)

What is her after-tax rate of return for the City of Heflin bond?

How much explicit tax does Melinda pay on the City of Heflin bond?

How much implicit tax does she pay on the City of Heflin bond?

How much explicit tax would she have paid on the Surething Inc. bond?

What is her after-tax rate of return on the Surething Inc. bond?

10. Hugh has the choice between investing in a City of Heflin bond at 6 percent or investing in a Surething Inc. bond at 9 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?

11. Hugh has the choice between investing in a City of Heflin bond at 6 percent or investing in a Surething Inc. bond at 9 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate, what interest rate does Surething Inc. need to offer to make Hugh indifferent between investing in the two bonds?

12. Fergie has the choice between investing in a State of New York bond at 5 percent and a Surething Inc. bond at 8 percent. Assuming that both bonds have the same nontax characteristics and that Fergie has a 30 percent marginal tax rate, in which bond should she invest?

Answer 1

Answer:

Requirement 9

after-tax rate of return

Since the City of Heflin bond is a tax exempt bond, Melinda’s after tax rate of return on the bond is equal to its pretax rate of return (6 percent).

Explicit Tax

Since the City of Heflin bond is a tax exempt bond, Melinda pays no explicit tax on the interest earned from the City of Heflin bond.

Implicit Tax

Melinda receives $12,000 of interest on the City of Heflin bond (i.e., 6% x $200,000). A comparable priced taxable bond (i.e., the Surething, Inc. bond) would pay $16,000 of taxable interest (i.e., 8% x $200,000). Melinda pays $4,000 of implicit tax on the City of Heflin bond (i.e., the variance among the pretax interest earned from a alike taxable bond ($16,000) and the pretax interest received from the City of Heflin bond ($12,000)).

Explicit Tax - Surething Inc.

Since Melinda’s marginal tax rate is 25 percent, she would have paid $4,000 of explicit tax (i.e., 25% x $16,000) on the interest earned from the Surething, Inc. bond.

After-tax rate of return on the Surething Inc. bond

Her after-tax income from the Surething, Inc. bond would be $12,000 ($16,000 interest income - $4,000 tax). Thus, her after-tax return from the Surething, Inc. bond would be 6 percent (after-tax income of $12,000 divided by her $200,000 investment).

Requirement 10

Hugh’s after tax rate of return on the tax exempt City of Heflin bond is 6 percent. The Surething bond pays taxable interest of 9 percent. Hugh’s after tax rate of return on the Surething bond is 5.4 percent (i.e., 9% interest income – (9% x 40%) tax = 5.4%). Hugh should invest in the City of Heflin bond.

Requirement 11

To be indifferent between investing in the two bonds, the Surething, Inc. bond should provide Hugh the same after-tax rate of return as the City of Heflin bond (6 percent). To solve for the required pretax rate of return we can use the following formula: After-tax return = Pretax return x (1 – Marginal Tax Rate).

Surething, Inc. needs to offer a 10 percent interest rate to generate a 6 percent after-tax return and make Hugh indifferent between investing in the two bonds – i.e.,

6% = Pretax return x (1 – 40%);
Pretax return = 6% / (1 – 40%) = 10%

Requirement 12

Fergie’s after tax rate of return on the tax exempt State of New York bond is 5 percent. The Surething bond pays taxable interest of 8 percent. Fergie’s after tax rate of return on the Surething bond is 5.6 percent (i.e., 8% interest income – (8% x 30%) tax = 5.6%). Fergie should invest in the Surething bond.