if i invest in municipal bonds that earn 5% interset or in taxable bonds issued by pepsi that pay 11% what is the tax rate at 15% and 30%; and what tax rate would there be indifferent between the bonds
To determine the tax rate at 15% and 30% and the tax rate at which there would be indifference between the municipal bonds and the taxable bonds, we need to compare the after-tax returns of both options.
1. Taxable Bonds issued by Pepsi:
- Interest rate: 11%
The interest earned on taxable bonds is subject to income tax. To calculate the after-tax return, subtract the tax amount from the interest earned:
- 15% tax rate: 11% - (11% * 15%) = 11% - 1.65% = 9.35%
- 30% tax rate: 11% - (11% * 30%) = 11% - 3.3% = 7.7%
2. Municipal Bonds:
- Interest rate: 5%
Municipal bond interest is typically exempt from federal income tax. Therefore, the after-tax return equals the interest rate earned:
- 15% tax rate: 5%
- 30% tax rate: 5%
To determine the tax rate at which there would be indifference between the bonds, we need to set the after-tax returns equal to each other:
Municipal Bonds After-Tax Return = Taxable Bonds After-Tax Return
5% = 11% - (11% * Tax Rate)
0.11 * Tax Rate = 0.11 - 0.05
0.11 * Tax Rate = 0.06
Tax Rate = 0.06 / 0.11
Tax Rate ≈ 0.54 or 54%
Therefore:
- At a 15% tax rate, the after-tax return for taxable bonds would be 9.35% and municipal bonds would be 5%.
- At a 30% tax rate, the after-tax return for taxable bonds would be 7.7% and municipal bonds would be 5%.
- The tax rate at which there would be indifference between the bonds is approximately 54%.