Assume that the tax rates on corporate taxable income up to $50000 is 15% and 25

Question

Assume that the tax rates on corporate taxable income up to $50000 is 15% and 25% for income levels between $50001 and $75000. If the Clumsy Chihuahua Music company has a taxiable income of $71000, then it has a tax liability of__________ and an average tax rate of__________.

suppose you want to invest $10000. You have two options:

option1: Invest in municipal bonds with an expected return of 13% or..

option2: Invest in the corporate bonds of jeffery inc. Which are offering an expected return of 18.85%

Assume that your decision is based solely on your tax situation . If everyonelse is same for both bonds, at what tax rate would you be indifferent between these two bonds investments?

A. 39.68% B. 31.00% C. 34.10% D. 28.83%

Explanation / Answer

Answer 1st Part:

Tax rates on corporate taxable income up to $50,000 is 15% and

Tax rate is 25% for income levels between $50,001 and $75,000.

Company has a taxable income = $71000

Hence,

Tax amount on corporate taxable income up to $50000 = $50,000 * 15% = $7,500

Tax amount for balance ($71,000 -$50,000=) $21,000 = $21,000 * 25% = $5,250

Hence Tax liability = $7,500 + $5,250 = $12,750

Average Tax rate = Tax Liability /Taxable Income = $12,750 /$71,000 = 17.96%

If the Clumsy Chihuahua Music Company has a taxable income of $71000, then it has a tax liability of $12,750 and an average tax rate of 17.96%

Answer 2nd Part:

Correct answer is:

B. 31.00%

Workings:

Option1: Invest in municipal bonds with an expected return of 13%

As interest on municipal bonds is tax free, post tax return is also = 13%

Option2: Invest in the corporate bonds of Jeffery Inc. and expected return = 18.85%

Interest earning on corporate bond is taxable.

Let us assume tax rate at which I would be indifferent between these two bonds investments = T%

I would be indifferent if post tax return is same.

Post Tax return of corporate bond = 18.85% * (1 - T %)

Hence,

18.85% * (1 - T %) = 13%

=> T = (18.85% - 13%) / 18.85% = 31.03%.

The closest option out of 4 options is B. 31.00%

Other options will not result in indifference point and hence are incorrect.

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