Question

Hugh has the choice between investing in a City of Heflin bond at 3.00 percent or a Surething bond at 4.25 percent. Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate. What interest rate does Surething Inc., need to offer to make Hugh indifferent between investing in the two bonds? (Round your answer to 2 decimal places.)

Answer 1

Hugh will pay tax on its interest income and hence teh after tax rate of income shall be = Interest rate * (1- tax)

City of Heflin bond is offreing a rate of 3% after tax rate of retrun, hence Surething should offer a interets rate that given Hugh after tax rate of 3%.

Tax rate is given 40% = 0.40

So

Interest rate * (1- tax) = 3%

Interest rate * (1- 0.40) = 0.03

Interest rate * 0.60 = 0.03

Interest rate = 0.03 / 0.60

Interest rate = 0.05 = 5%

Hence Surething should offer 5% interets rate