Question

Melinda invests $200,000 in a City of Heflin bond that pays 6 percent interest. Alternatively, Melinda could have invested the $200,000 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 25 percent. (Leave no cells blank - be sure to enter "0" wherever required.)

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

        

b. How much explicit tax does Melinda pay on the City of Heflin bond?

        

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

        

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

        

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

       

Answer 1

(a) Computation of the after-tax rate of return for the City of Heflin bond.We have,

Since, the City of Heflin bond is government bond, so it is tax exempt bond. Melinda's after tax rate of return is equal to its pretax rate of return.

Hence, Ater-tax rate of return for the City of Heflin bond is 6%.

(b) Computation of the explicit tax does Melinda pay on the City of Heflin bond.We have,

Since, the City of Heflin bond is government bond and it is tax exempt bond. So, Melinda pays no explicit tax on interest earned on the City of Heflin bond.

(c) Computation of the implicit tax that pay on the City of Heflin bond. We have,

Interest earned on the City of Heflin bond = 200,000 x 6 % = $ 12,000

Interest earned on the similar kind of taxable bond = 200,000 x 8 % = $ 16,000

Implicit tax on the City of Heflin bond = 16,000 - 12,000 = $ 4,000

Note: Implicit cost is the he difference between the pretax interest earned from a similar taxable bond ($16,000) and the pretax interest earned from the City of Heflin bond ($12,000).

(d) Computation of the explicit tax that paid on the Surething Inc. bond.We have,

Interest earned on the Surething Inc. bond = 200,000 x 8 % = $ 16,000

Marginal tax on the Surething Inc. bond = 16,000 x 25% = $ 4,000

Hence, the explicit tax that paid on the Surething Inc. bond is $ 4,000.

(e) Computation of the after-tax rate of return on the Surething Inc. bond.We have,

Interest earned on the Surething Inc. bond = 200,000 x 8 % = $ 16,000

Marginal tax on the Surething Inc. bond = 16,000 x 25% = $ 4,000

After-tax income = 16,000 - 4,000 = $ 12,000

After-tax rate of return = After-tax income / Total Investment

After-tax rate of return = 12,000 / 200,000 = 0.06*100 = 6 %

Hence, the after-tax rate of return on the Surething Inc. bond is 6%.