Problem 3: Suppose the only nancial instruments available in Minneapolis are a t

ID: 2383516 • Letter: P

Question

Problem 3: Suppose the only nancial instruments available in Minneapolis are a taxable
Federal Treasury Bill (T-Bill) and a municipal bond from the city of Minneapolis. The municipal bond is tax exempt. Assume both the municipal bond and the taxable bond are risk free, i.e. there is no chance of default for each.

A. The before-tax rate of return on the T-Bill is 8 percent, while the municipal bond returns 5.5 percent. Minnesota taxes all interest income at a rate of 25 percent. What fraction of his wealth, w, will the investor invest in the municipal bond? Why?

B. Now, the before-tax rate of return on the T-Bill is 6 percent. The state taxes all interest income at a rate of 12.5 percent. The municipal bond has a rate of return of r percent. What should the City of Minneapolis set r equal to so that investors are indifferent between investing in the taxable bond and investing in the municipal bond?

D. Call G = (t, rm) a goverment policy. Given r, illustrate in a graph that has rm on the vertical axis and t in the horizontal axis the collection of all government policies that leave the investor indi erent between investing in the two types of bonds.

Explanation / Answer

Analysis for investment in bonds:

Bond type

T-Bill

Municipal bond

Assume bond value

1000

Pre-tax return

5.50%

Less:

Tax @25%

Exempt

Net return

Since, the net return is more in T-bill, the investment in municipal bond will be zero and both are risk free.

Note:

When the risk for the two bonds is same, the net return is preferred for investment.