Corporate bonds issued by Johnson Corporation currently yield 8.5%. Municipal bonds of equal risk currently yield 6%. At what tax rate would an investor be indifferent between these two bonds? Round your answer to two decimal places.

Question

Corporate bonds issued by Johnson Corporation currently yield 8.5%. Municipal bonds of equal risk currently yield 6%. At what tax rate would an investor be indifferent between these two bonds? Round your answer to two decimal places.

The answer I keep coming up with is incorrect. I use this formula: 8.5(1-.06)=7.99, but when i work the homework problem in the book I get a different answer.

Answer 1

Bond Yield Example Data

A B

1 FV 1000
2 Annual Coupon Rate 7.5%
3 Annual Return 5.5%
4 Years to Maturity 14
5 Years 1
6 Payment Frequency 1
7 Value of Bond 1191.79

PUT THIS IN EXCEL AND YOU HAVE A CALCULATOR

VALUE OF BOND=
=-PV(B4/B7,B5*B7,B3/B7*B2,B2)

Answer 2

To determine the tax rate at which an investor would be indifferent between investing in corporate bonds and municipal bonds, we need to consider the after-tax yield of each bond.

Let's break down the calculation step by step:

1. Calculate the after-tax yield of the corporate bond: We subtract the tax rate from 1 to get the portion of the yield that is not taxed, and then multiply it by the yield of the corporate bond.
After-tax yield of corporate bond = 8.5% × (1 - tax rate)

2. Calculate the after-tax yield of the municipal bond: Since municipal bond yields are typically tax-exempt, the after-tax yield is equal to the pre-tax yield.
After-tax yield of municipal bond = 6%

Now, when the investor is indifferent between these two bonds, the after-tax yields should be the same. Therefore, we set up the equation:

8.5% × (1 - tax rate) = 6%

To solve for the tax rate, let's rearrange the equation and isolate the tax rate term:

(1 - tax rate) = (6% / 8.5%)
1 - tax rate = 0.70588

Now, solve for the tax rate:

tax rate = 1 - 0.70588
tax rate ≈ 0.29412

Rounded to two decimal places, the investor would be indifferent between the two bonds at a tax rate of 29.41%.

It's important to double-check your calculations and ensure you are using the correct formula and values from the problem statement. Mistakes in calculations can lead to incorrect answers. If you're still having trouble, it might be helpful to review the problem and double-check your steps.