Question

Beau would like to invest in bonds and is considering either a taxable bond with an interest rate of 5% or a tax-exempt municipal bond of comparable risk and quality with an interest rate of 3%. Beau's marginal tax rate is 25%. In order to help Beau compare these two bonds, compute the equivalent taxfree rate for the taxable bond.

Answer 1

3.75%

Explanation:

The computation of equivalent tax-free rate for the taxable bond is shown below:-

The Equivalent tax-free rate for the taxable bond = Interest rate × (1 - Marginal tax rate)

= 5% × (1 - 25%)

= 5% × 0.75%

= 3.75%

Therefore for computing the Equivalent tax-free rate for the taxable bond we simply applied the above formula.