Suppose a municipal bond offers a yield to maturity of 5% and a same maturity corporate...

Suppose a municipal bond offers a yield to maturity of 5% and a same maturity corporate bond offers a 4% yield. For which values of the marginal tax rate an investor would prefer to buy the corporate bond? A. The investor would prefer to buy the corporate bond if she faces a marginal tax rate greater than 40%. B. The investor would prefer to buy the corporate bond if she faces a marginal tax rate lower than 20%. C. The investor would prefer to buy the corporate bond if she faces a marginal tax rate greater than 20%. D. The investor would prefer to buy the corporate bond if she faces a marginal tax rate lower than 40%.

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Expert Solution

In the above question, the investor would buy Municipal bond irrespective of the marginal tax rate as the YTM on municipal bond (tax free) is greater than the YTM on corporate bonds.

So assuming the question is wrong such that YTM on municipal bond is 4% and YTM on corporate bond is 5%, then

YTM of Municipal bond(Rm) = 4%

YTM of corporate bond (Rc) = 5%

To be indifferent between the two bonds, after tax yield on coporate bonds must be equal to the yield on municipal bonds.

Rc*(1-t) = Rm

(1-t) = 4%/5%

t = 20%

Answer is B. The investor would prefer to buy the corporate bond if she faces a marginal tax rate lower than 20%

jeff jeffy answered 2 years ago

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