Rob is currently considering investing in municipal bonds that earn 4 percent interest or taxable bonds issued by Dell Computer that pay 6.5 percent. If Rob's tax rate is 20 percent, which bond should he choose? Which bond should he choose if his tax rate is 30 percent? At what tax rate would he be indifferent to the municipal bond or to the corporate bond? What strategy is this decision based upon?

Question

What will be an ideal response?

Answer 1

Rob's after-tax rate of return on the tax-exempt bond is 4 percent (i.e., the same as its pretax rate of return). The Dell Computer bond pays taxable interest of 6.50 percent. Rob's after-tax rate of return on the Dell Computer bond is 5.20 percent (i.e., 6.50 percent interest income ? (6.50% × 20%) tax = 5.20%). Rob should invest in the Dell Computer bond.
If Rob's marginal tax rate is 30 percent, his after-tax rate of return on the Dell Computer bond would be 4.55 percent (i.e., 6.50% interest income ? (6.50% × 30%) tax = 4.55%). Rob should invest in the Dell Computer bond in this situation.
Rob would be indifferent between the two bonds if his marginal tax rate is 38.46 percent.
After-tax return = Pretax return × (1 ? marginal tax rate)
4% = 6.50% × (1 ? marginal tax rate) = 6.50% ? (6.50% × marginal tax rate)
6.50% marginal tax rate = 2.50%
Marginal tax rate = 2.50%/6.50% = 38.46%
This example is an illustration of the conversion planning strategy.