(For the two problems below, analyze using one-year horizon.)
Q1. If municipal bonds generate a pretax return of 7%, and similar risk fully taxable bonds generate
pretax return of 10%. If a bank faces a marginal tax rate of 40%, does it make sense for the bank to issue
$1,000 taxable bonds at interest rate R=10% and invest the proceeds ($1,000) in municipal bonds?
Assume that the tax law allows banks to fully deduct the interest expense on loans that are used to
purchase municipal bonds.
Q2. If Congress passed a law limiting the deductibility of interest expense on loans used to purchase
municipal bonds to 20%80%. For example, borrowing $1,000, only $20 of the $100 interest expense is
deductible. Would the tax arbitrage strategy still be profitable?
