Question

1. What is the discount yield, bond equivalent yield, and effective annual return on a $1 million T-bill that currently sells at 97 3/8 percent of its face value and is 55 days from maturity? (Use 360 days for discount yield and 365 days in a year for bond equivalent yield and effective annual return. Do not round intermediate calculations. Round your answers to 3 decimal places. (e.g., 32.161))

Discount yield	%
Bond equivalent yield	%
Effective annual return	%
2. You can invest in taxable bonds that are paying a yield of 8.2 percent or a municipal bond paying a yield of 6.75 percent. Assume your marginal tax rate is 21 percent. a. Calculate the after-tax rate of return on the taxable bond? (Round your answer to 2 decimal places. (e.g., 32.16))   Rate of return % b. Which security bond should you buy? Taxable bonds that are paying a 8.2 percent annual rate of return. Municipal bond paying a 6.75 percent annual rate of return. 3. A client in the 30 percent marginal tax bracket is comparing a municipal bond that offers a 4.5 percent yield to maturity and a similar risk corporate bond that offers a 6.25 percent yield. Which bond will give the client more profit after taxes? Municipal bond Corporate bond

Answer 1

1. Discount Yield = Discount / Par Value * 360 / Days to Maturity = (100 - 97.375) / 100 * 360 / 55 = 17.182%

Bond Equivalent Yield = Discount / Purchase Price * 365 / Days to Maturity = 2.625 / 97.375 * 365 / 55 = 17.890%

Effective Annual Return = (Par Value / Purchase Price) ^ (365 / Time to Maturity) - 1 = (100/97.375)^(365/55) -1 = 19.307%

2. (a) After-tax return on taxable bond = Pre-tax Yield * (1 - Marginal Tax rate) = 8.2% * ( 1- 0.21) = 6.48%

(b) Municipal bonds are tax exempt, and in this case, the after-tax yield of municipal bond is higher (6.75%) than that of the taxable bond (6.48%). Hence, you should buy the municipal bond in this case.

3. Doing similar calculations as in (2) above.

After-tax yield on corporate bond = 6.25% * (1 - 0.30) = 4.375%

Municipal bonds (being tax exempt) would have after-tax yield of 4.50%

The municipal bond will give the client more profit after taxes.