Answer: Surething Inc, needs to issue bonds with 11% interest rate in order to make Hugh indifferent between investing in two bonds.
We arrive at the answer in the following manner:
The City of Helfin bonds are municipal bonds and hence they are tax free. This means that Hugh will get an after - tax return of 6.6%.
The bonds of Surething Inc offering a 10% interest, however are taxed at 40%. So, the current after-tax returns of the bond is:
[tex] After - tax return= Pre- tax return * (1 -tax rate) [/tex]
[tex] After-tax return= 0.1 * (1-0.4) [/tex]
Current after tax return = 0.06 or 6%
However Hugh will be indifferent to investing in these two bonds only if they offer the same after-tax return of 6.6%.
Given this, we can calculate the indifference rate as follows:
[tex] After - tax return= Pre- tax return * (1 -tax rate) [/tex]
[tex] 0.066= Pre- tax return * (1 -0.4) [/tex]
[tex] \frac{0.066}{0.6}= Pre-tax return [/tex]
Pre-tax return = 0.11 or 11%.
