A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 25.00%. What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax return?

Question

Business

Lailah Schmidt

7 May, 02:37

A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal taxes) is 25.00%. What interest rate on a 7-year corporate bond of equal risk would provide you with the same after-tax return?

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Answers (1)

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Yuliana Tate · Answer 1

The answer is 6.40%.

Explanation:

As the corporate bond of equal risk to municipal bond (that is, the return on the corporate bond should not be higher for compensating higher risk in comparison to municipal bond), the after-tax return on the municipal bond should be equal to the municipal bond yield (because income from municipal bonds is tax-free) to make the return on the two financial asset indifferent. In other words, only tax factor that differentiate the nominal returns of these two equal risk-adjusted return financial assets.

Denote x is the return on corporate bond needs to be found. We haveL

4.8% = x * (1-tax rate) 4.8% = x * 75% x = 6.40%

So, the answer is 6.40%.