Question

If the municipal yield is 6%, what (pre-tax) taxable yield would a private bond issuer have to offer in order to make you indifferent between the two bonds if your tax rate is 45%?

I need step by step instructions please

Answer 1

As the municipal bond is yielding 6% interest on investment that is called coupon rate. Rate of return on municipal bonds is also called as Risk free return. (This is Risk free investment as well)

So,In order to make indifference from municipal bond, private issuer have to offer more interest rate than municipal bond. ie. More interest rate than Risk free return kn investment.

[As CAPM(Capital Asset Pricing Method) explains that higher the risk higher should be the return. As the risk goes on increasing, Expected return on investment should also Increase.] Ie. Municipal bond are risk free bond, while private bond is risky. So, In order to make indifferent private issuer have to offer more return on the following investment.

Calculation: Risk free return (Rf) = 6%

Corporate tax(Tax) = 45% ie. 100

In order to make inference: [Rf/(100 - Tax)] ×100

Ie. [6%/(100-45)]×100

=〉 [6/55]100

=〉 0.10909091 ×100

=〉 10.909091% ≈ 10.91%(pre-tax)

So in order to make indifference private bond issuer have to offer 10.91% (pre-tax) interest on private bonds.