Question

Ariel invests $60,000 in a city of Charlotte bond that pays 5% interest. Alternatively, Ariel could have invested the $60,000 in a bond recently issued by Java Jerry’s Inc. that pays 7% interest with similar non-tax characteristics as the city of Las Vegas bond (e.g., similar risk). Assume that Ariel’s marginal tax rate is 25%. What is her after-tax rate of return for the city of Charlotte bond? For the Java Jerry’s, Inc. bond? How much explicit tax does Ariel pay on the city of Charlotte bond? How much implicit tax does she pay on the city of Charlotte bond? How much explicit tax would she have paid on the Java Jerry’s, Inc. bond? Which bond should she choose?

Answer 1

The bond of Charlotte is tax exempt. Ariel’s after tax rate of return should therefore equal to its pre=tax rate of return(5%). Ariel pays no explicit tax on interest earned from the city of Charlotte bond.

The Java Jerry’s bond pays 60,000*7% = $4,200 interest. As the marginal tax rate of Ariel is 25%, she would have to pay $4200*25% = $ 1050 on interest earned from Java Jerry bond. Her after tax rate of return would be (4200-1050)/$60,000 = 5.25%.

Ariel also earns $60,000 * 5% = $ 3000 on interest from city of Charlotte bond. Similar bond with taxable characteristic pays Ariel $ 4,200 of taxable interest. Ariel pays implicit tax of $ 1200 on city of Charlotte bond. Implicit tax rate is notional tax rate here which is the difference between pre-tax interest earned from taxable bond i.e. $ 4200 and pre-tax interest from Charlotte city bond i.e. $ 3000. Ariel should, therefore, chose Java Jittery’ bond because it earns higher after tax return of 5.25% which is greater than the after tax return of Charlotte bond i.e. 5%.

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