Question

Melinda invests $310,000 in a City of Heflin bond that pays 5.6 percent interest. Alternatively, Melinda could have invested the $310,000 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 30 percent.

Required:

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

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

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

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

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

Answer 1

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

After tax rate of return is 5.60% because the City bonds are tax empt

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

as the bond is tax exempt there is is no explicit tax

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

Implicit tax = Return on similar bond - return from heflin bond

Implicit tax = 310000 * 8% - 310000 * 5.60%

Implicit tax = $7440

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

explicit tax = interest on bond * tax rate

explicit tax = 310000 * 8% * 30%

explicit tax = $7440

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

After tax return = coupon rate * (1 - tax) = 8% * 0.70 = 5.60%