Question

Mantle Corporation is considering two equally risky investments: ∙ A $5,000 investment in preferred stock that yields 7.75%. ∙ A $5,000 investment in a corporate bond that yields 10%. What is the breakeven corporate tax rate that makes the company indifferent between the two investments? Assume a 70% dividend exclusion for tax on dividends. (Do not round your intermediate answer and round your final answer to two decimal places.)

Answer 1

Answer:

At a corporate tax rate of 16.29%, both investment shall have same income, so it will be the indifference point.

Explanation:

Let take X to be the corporate tax rate

Note that 70% dividend exclusion for tax on dividend mean 30% is actually applied to dividend

Preferred dividend = 5000 * 7.75% = 387.5

Taxable dividend = 387.5 * 30% = 116.25

Interest on bond = 5000*10% =  500

For the purpose of Indifference  of the two investment brought about by the two break-even corporate tax

387.5 - 116.25  * X = 500 - 500*X

500 X - 116.25  X = 500 - 387.5

383.75 X = 175 -112.5

383.75 X = 62.5

X= 62.5/383.75

X= 0.1629

X=16.29%

At a corporate tax rate of 16.29%, both investment shall have same income, so it will be the indifference point.