Question

Jackson has the choice to invest in city of Mitchell bonds or Sundial, Inc. corporate bonds that pay 5.4 percent interest. Jackson is a single taxpayer who earns $45,000 annually. Assume that the city of Mitchell bonds and the Sundial, Inc. bonds have similar risk.

What interest rate would the city of Mitchell have to pay in order to make Jackson indifferent between investing in the city of Mitchell and the Sundial, Inc. bonds for 2019? (Use tax rate schedule)

Multiple Choice

• 3.61 percent

• None of the choices are correct

• 5.40 percent

• 4.21 percent

• 4.41 percent

Answer 1

Please note that as per the question, we need to calculate the rate at which Jackson would be indifferent in investing in Mitchell city bonds vs Sundial Inc corporate bonds.

The city bonds are generally tax free and corporate bonds are taxed at marginal tax rate of the taxpayer. Hence, we need to calculate the after tax rate of return on corporate bonds where Jackson would be indifferent in his investment.

The taxpayer with an income of $45,000 would fall under the 22% Marginal tax rate for 2019 as per the IRS.

The after tax rate of return on bonds is calculated as = 5.4% - (5.4% * 0.22)

The after tax rate of return on bonds = 5.4% - 1.188%

The after tax rate of return = 4.212%

Based on the above calculation, the correct answer is Option D - 4.21%

Option A and Option E are incorrect based on the above calculations.

Option B is incorrect because we have the answer at Option D.

Option C is incorrect because 5.40% is not the rate at which Jackson will be indifferent since the interest on corporate bonds are taxed at the prevailing marginal tax rates.