Question

Janice Wilcox is a wealthy investor​ who's looking for a tax shelter. Janice is in the maximum ​(37​%) federal tax bracket and lives in a state with a very high state income tax.​ (She pays the maximum of 12.3​% in state income​ tax.) Janice is currently looking at two municipal bonds, both of which are selling at par. One is a ​AA-rated in-state bond that carries a coupon of 6.806%. The other is a ​AA-rated, out-of-state bond that carries a coupon of 7.273​%.

Her broker has informed her that comparable fully taxable corporate bonds are currently available with yields of 10.068​%. Alternatively, long Treasuries are now available at yields of 9.369​%. She has​ $100,000 to​ invest, and because all the bonds are​ high-quality issues, she wants to select the one that will give her maximum​ after-tax returns.

a. Which one of the four bonds should she​ buy?

b. Rank the four bonds​ (from best to​ worst) in terms of their taxable equivalent yields.

a. The taxable equivalent yield on the​ in-state municipal bond is

______%. ​(Round to three decimal​ places.)

Answer 1

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield.

Q(b) To rank the four bonds from best to worst in terms of their taxable equivalent yields, we need to calculate taxable equivalent yield for each bond.

Taxable equivalent yield = Yield on the tax-free bond / Reciprocal of your tax rate**

** Reciprocal of your tax rate = ( 1 - Tax rate ) = ( 1 - 37% ) = 0.63

1. AA-rated in-state bond = 6.806 / 0.63 = 10.803%

2. AA-rated, out-of-state bond = 7.273 / 0.63 = 11.544%

3. Fully taxable corporate bonds = 10.068 / 0.63 = 15.981%

4. Long Treasuries = 9.369 / .63 = 14.871%

The above calculations helps us to rank the bonds. They can be ranked as follows :-

1.Fully Taxable corporate bonds 2.Long Treasuries 3. AA-rated out of state bond 4.AA-rated in state bond.

Q(a) She should buy the Fully taxable corporate bonds as they give the highest taxable equivalent yield.

Q(c) The taxable equivalent yield on the​ in-state municipal bond is 10.803%. ​