Suppose a foreign investor who holds tax-exempt Eurobonds paying 9% is considering investing in an equivalent-risk domestic bond in a country with a 28% withholding tax on interest paid to foreigners. If 9% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return

Question

Jace Guerra

Business

27 November, 22:26

Suppose a foreign investor who holds tax-exempt Eurobonds paying 9% is considering investing in an equivalent-risk domestic bond in a country with a 28% withholding tax on interest paid to foreigners. If 9% after-tax is the investor's required return, what before-tax rate would the domestic bond need to pay to provide the required after-tax return

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Jaylynn Blair · Answer 1

Investor's before required rate of return is 12.5%

Explanation:

The investor required return is the pretax return on the investment before applying the tax rate of 28%.

The pretax rate of return on the investment can be computed using the after tax return formula below by changing the subject of the formula to pretax rate of return;

After rate of return=pretax rate of return * (1-t)

t is the tax rate of 28% or 0.28

pretax rate of return is unknown

after tax rate of return is 9%

pretax rate of return=after tax rate of return / (1-t)

pretax rate of return=9% / (1-0.28)

pretax rate of return=9%/0.72

pretax rate of return = 12.5%