Nelson Has the Choice Between Investing in a City of Fruithurst

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The Answer is Nelson's after-tax rate of return on the tax-exempt city of Fruithurst bond is 4 percent.The J.B.Ribs, Inc.bond pays taxable interest of 6.5 percent.Nelson's after-tax rate of return on the J.B.Ribs, Inc.bond is 3.9 percent (i.e., 6.5% interest income − (6.5% × 40%)tax = 3.9%).Nelson should invest in the city of Fruithurst bond.
For Nelson to be indifferent between investing in the two bonds, the J.B. Ribs, Inc. bond should provide Nelson the same after-tax rate of return as the city of Fruithurst bond (4 percent). To solve for the required pretax rate of return we can use the following formula: After-tax return = Pretax return × (1 − Marginal Tax Rate).

J.B. Ribs, Inc. needs to offer a 6.67 percent interest rate to generate a 4 percent after-tax return and make Nelson indifferent between investing in the two bonds.

4% = Pretax return × (1 − 40%);
Pretax return = 4% / (1 − 40%) = 6.67%

Nelson Has the Choice Between Investing in a City of Fruithurst

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