An investor can invest in either a tax-exempt security that pays 5%,or a taxable corporate security of comparable risk and maturity that pays 8%.At what marginal tax rate will the investor be indifferent between these two securities?
A)25.0%
B)32.5%
C)37.5%
D)57.5%
E)62.5%

Question

Quizplus · Accepted Answer

The investor will be indifferent when the after-tax return of the taxable security equals the return of the tax-exempt security. The formula to find the marginal tax rate (T) at which an investor would be indifferent is given by the return of the tax-exempt security (R_tax_exempt) divided by the return of the taxable security (R_taxable), or T = R_tax_exempt / R_taxable. Plugging in the given values, T = 5% / 8% = 0.625 or 62.5%. However, to find the marginal tax rate at which the investor is indifferent, we adjust the formula to account for the fact that the investor keeps (1 - T) of the taxable return. So, we set 5% = 8% * (1 - T), solving for T gives us T = 37.5%.

An Investor Can Invest in Either a Tax-Exempt Security That