Question

Assume Vandell, a individual taxpayer, is in a 25 percent tax bracket. He invests in Otay Mesa Water District Bonds that pay 4.5 percent interest. What interest on a taxable bond would provide the same after-tax return to Vandell? Enter your answer as a percentage, rounded to two decimal places. __________%

Answer 1

Otay Mesa Water District Bonds are tax free bonds.

They are providing Vandell with 4.5% interest.

So Vandell's after tax return is also 4.5%.

So we have to calculate a pre-tax return that would be providing the same after tax-return as of Otay Mesa Water District Bonds. Let's assume this return to be x%

Vandell is in the 25% tax bracket, so Vandell's interest will be taxed at 25%.

So what we want is,

x ( 100 % - 25 % ) = 4.5

x = 6

So the required return on taxable bond is 6%.