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In: Accounting

Q2: Jorge and Anita, married taxpayers, earn $140,000 in taxableincome and $40,000 in interest from...

Q2: Jorge and Anita, married taxpayers, earn $140,000 in taxable income and $40,000 in interest from an investment in City of Heflin bonds.  

1. how much federal tax will they owe?  

Q3: Melinda invests $100,000 in a City of Heflin bond that pays 6.4 percent interest. Alternatively, Melinda could have invested the $100,000 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.

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

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

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

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

Q4: 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 35 percent marginal tax rate.

1. What interest rate does Surething, Inc. need to offer to make Hugh indifferent between investing in the two bonds?

Solutions

Expert Solution

Q2.) The interest of $40,000 from City of Heflin bonds is tax exempt, so the federal tax would be levied only on the taxable income of $140,000.

The Federal tax based on the 2019 tax tables = 9086 + 22% * ($140,000 - $78,950) = $22,517

This is based on the IRS Slabs for joing filing for 2019 , which levies 10% for $0 to $19400 income

12$ for $19,401 to $78,950 income and 22% for $78,951 to $,168,400 income.

Alternatively, tax can also be found using the formula of $140,000 * 22% - $8,283 = $22,517

Note:- All the above details are for the tax tables of 2019 as issued by IRS, you can adjust the answer is some other year tax figures are required. Since the question is silent as to the tax year, recently used table of 2019 is being preferred.

Q3.) 1) The after-tax rate of return for the City of Heflin bond is 6.4% because the interest is tax exempt.

2) The implicit tax does she pay on the City of Heflin bond can be determined by the difference in interest rates of City of Heflin bond and  bond issued by Surething, Inc. which has  similar risk and other nontax characteristics.

For finding the implicit tax, we use this formula, = 1 - (Interest on tax Exempt Bonds / Interest on taxable bonds) = 1 - (6.4 / 8) = 1 - 0.8 = 0.2 or 20%

3) The explicit tax that she would have paid on the Surething, Inc. bond is 20% (her Marginal tax Rate), which would amount to 20% of 8% = 1.6% in terms of interest on bons.

4) Her after-tax rate of return on the Surething, Inc. bond = 8% - (20% of 8%) = 8% - 1.6% = 6.4%

Hence, in effect, the after tax return of both the instruments is equal.

Q.4) The interest rate requierd to be offered by Surething, Inc. in order to make Hugh indifferent between investing in the two bonds = Tax free interest rate / ( 1 - Applicable Tax Rate) = 6% / (1 - 35%) = 6% / 0.65 = 9.23%

Hence, at an interest rate of 9.23% on Surething, Inc. bonds, Hugh would be ndifferent between investing as both the options would yield the same tax free return of 6%.


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