A 5-year corporate bond yields 10.70%. A 5-year municipal bond of equal risk yields 6.50%. Assume that the state tax rate is zero. At what federal tax rate are you indifferent between the two bonds? (Round your final answer to two decimal places.)

The multiple choices are as follows:

a.

25.40%

b.

29.03%

c.

39.25%

d.

33.98%

e.

27.38%

The correct option is C, 39.25% federal tax rate

Explanation:

In determining the federal tax that one would be indifferent in choosing between the two bonds, we equate the yield of the two bonds as follows with tax element being deducted from corporate bond yield:

6.50%=10.70% * (1-t)

The t is the tax rate which is the unknown

divide both sides by 10.70%

6.50%/10.70%=1-t

0.607476636 = 1-t

t=1-0.607476636

t=0.392523364 = 39.25%