Question

1.) Melinda invests $300,000 in a City of Heflin bond that pays 6.4 percent interest. Alternatively, Melinda could have invested the $300,000 in a bond recently issued by Surething, Inc. that pays 8 percent interest with similar risk and other nontax characteristics to the City of Heflin bond. Assume Melinda’s marginal tax rate is 20 percent. How much explicit tax would she have paid on the Surething, Inc. bond?

2.) Melinda invests $300,000 in a City of Heflin bond that pays 6.4 percent interest. Alternatively, Melinda could have invested the $300,000 in a bond recently issued by Surething, Inc. that pays 8 percent interest with similar risk and other nontax characteristics to the City of Heflin bond. Assume Melinda’s marginal tax rate is 20 percent. What is her after-tax rate of return on the Surething, Inc. bond?

3.)Hugh has the choice between investing in a City of Heflin bond at 6 percent or a Surething bond. Assuming that both bonds have the same nontax characteristics and that Hugh has a 28 percent marginal tax rate. What interest rate does Surething, Inc. need to offer to make Hugh indifferent between investing in the two bonds?

Answer 1

1
Explicit tax on the Surething, Inc. bond	4800	=300000*8%*20%
2
After-tax rate of return on the Surething, Inc. bond	6.4%	=8%*(1-20%)
3
Indifferent interest rate	8.33%	=6%/(1-28%)