Fisher Brown is taxed at 40% on his income from ordinary bonds. Ordinary bonds pay 10% interest. Interest on municipal bonds is not taxed at all.
(a) If the interest rate on municipal bonds is 7%, should he buy municipal bonds or ordinary bonds?
(b) Hunter Black makes less money than Fisher Brown and is taxed at only 25% on his income from ordinary bonds. Which kind of bonds should he buy?
(c) If Fisher has $1,000,000 in bonds and Hunter has $10,000 in bonds, how much tax does Fisher pay on his interest from bonds?_____. How much tax does Hunter pay on his interest from bonds? _______.
(d) The government is considering a new tax plan under which no interest income will be taxed. If the interest rates on the two types of bonds do not change, and Fisher and Hunter are allowed to adjust their portfolios, how much will Fisher’s after-tax income be increased? ________. How much will Hunter’s after-tax income be increased? _______.
(e) What would the change in the tax law do to the demand for municipal bonds if the interest rates did not change?
(f) What interest rate will new issues of municipal bonds have to pay in order to attract purchasers?
(g) What do you think will happen to the market price of the old municipal bonds, which had a 7% yield originally?