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17 October, 03:11

Corporate bonds issued by Johnson Healthcare currently yield 8 percent. Municipal bonds of equal risk currently yield 6 percent. At what tax rate would an investor be indifferent between these two bonds?

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  1. 17 October, 03:29
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    a tax-rate for 25% will make the investor be indifferent between there two bonds

    Explanation:

    The Municipal bonds are tax free. Therefore, do not pay the income tax for their interest.

    We need to set and equation for the net yield of the bonds after tax, which equal the municipal bond:

    debt after tax:

    cost of debt (1 - t) = after-tax

    we want to equalize 8% pre-tax with 6% after-tax

    0.08 (1 - t) = 0.06

    t = 1 - 0.06/0.08 = 1 - 0.75 = 0.25 = 25%

    a tax-rate for 25% will make the investor be indifferent between there two bonds
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