Question

Fergie has the choice between investing in a State of New York bond at 6.9 percent and a Surething Inc. bond at 10.8 percent. Assuming that both bonds have the same nontax characteristics and that Fergie has a 30 percent marginal tax rate, what interest rate does the state of New York bond need to offer to make Fergie indifferent between investing in the two bonds? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Interest rate %

Answer 1

Fergie Fergie's after tax rate of return on the tax exempt State of New York bond is 6.9 percent. The Surething bond pays taxable interest of 10.8 percent. Fergie's after tax rate of return on the Surething bond is 5.6 percent (i.e., 10.8% interest income -(10.8% x 30%) tax = 7.56%). Fergie should invest in the Surething bond. Congress Based on the information above, the average taxpayer pays $6,200 of tax (i.e., $62,000 X 10%), leaving $55,800 of income after tax. A 11.5 percent increase in revenues would mean that the average taxpayer pays $6,913 in tax ($6,200 x 1.115). With this new tax amount, we can solve for the tax rate that would generate this tax amount. After-tax income = Pretax income x (1 -tax rate) After-tax income = Pretax income-(Pretax income x tax rate) After-tax income = Pretax income - Tax Substituting information from the problem results in: $55,800 = Pretax income - $6,913 Pretax income = $62,713 We can use the above formula to solve for the new tax rate. After-tax income = Pretax income x (1 -tax rate) $55,800 = $62,713 x (1-tax rate) Tax rate = $6,913/$62,713 = 11.02%