A corporate bond is paying 8% and a municipal bond of similar risk is paying 5.5

Question

A corporate bond is paying 8% and a municipal bond of similar risk is paying 5.5%, which would you prefer if you were currently in the 32% tax bracket: a) Buy the corporate bond since the break-even tax rate is 68.75% which is greater than our tax rate of 32%, b) a) Buy the corporate bond since the break-even tax rate is 68.75% which is greater than our tax rate of 32%. c) Buy the corporate bond since the break-even tax rate is 31.25% which is less than our tax rate of 32%. d)Buy the corporate bond since the break-even tax rate is 45.45% which is greater than our tax rate of 32%. e) Buy the municipal bond since the break-even tax rate is 45.45% which is greater than our tax rate of 32%.

Explanation / Answer

Break even tax rate is the rate at which the tax payer would be indifferent to investment in a taxable security and a non taxable security.

The income generated from municipal bonds is exempt from tax.

The applicable tax rate of the investor is 32%.

After tax return on corporate bonds=68%

Let x be the break tax rate.

0.08*(1-x) = 0.055

1-x =.055/0.08

1-x =0.6875

x= 1-0.6875

x=31.25%

Option B is not correctly pasted in the question.

But the decision basing on the above calculation would be to invest in municipal bond as the break even tax rate is less then the effective tax rate which is 32%.

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