Question

A corporation can earn 7.5% if it invests in municipal bonds. The corporation can also earn 8.30% (before-tax) by investing in preferred stock. Assume that the two investments have equal risk. What is the break-even corporate tax rate that makes the corporation indifferent between the two investments? Assume a 70% dividend exclusion for tax on dividends. (Do not round your intermediate answer and round your final answer to two decimal places.)

Answer 1

Answer:

32.13%

Explanation:

The computation of the break-even corporate tax is shown below:

As we know that

Municipal bond return = preferred stock return before tax  × [1 - (1 - dividend exclusion) × Break even corporate tax]

7.5 = 8.30 ×  [1 - ( 1 - 0.70) × Break even corporate tax ]

7.5 ÷ 8.30 = 1 - 0.30 × Break even corporate tax

0.9036 = 1 - 0.30 × Break even corporate tax

0.30 × Break even corporate tax = 1 - 0.9036

So, Break even corporate tax is

= 0.0964 ÷ 0.30

= 32.13%

Basically we applied the above formula