Question

An investor is comparing the following two bonds: a bond from ABC Corp which pays an interest rate of 9 percent per year and a municipal bond which pays an interest rate of 7.9 percent per year. The investor is in the 15 percent tax bracket. Which bond will give the investor a higher after-tax interest rate and for which reason? Question options:

The ABC bond because it pays a 9 percent interest rate, while the municipal bond only pays 7.9 percent.

The ABC bond because it pays an equivalent after-tax rate of 10.6 percent, while the municipal bond pays out an equivalent after-tax rate of 9.3 percent.

The municipal bond because it pays an equivalent after-tax rate of 9.3 percent, while the ABC bond pays out a 9 percent interest rate.

The municipal bond because it pays an equivalent after-tax rate of 7.9 percent, while the ABC bond pays out an equivalent after-tax rate of 7.65 percent. None of the above is correct.

Answer 1

Answer is:

The municipal bond because it pays an equivalent after-tax rate of 7.9 percent, while the ABC bond pays out an equivalent after-tax rate of 7.65 percent.

Explanation:

Municipal Bonds

Municipal bonds are debts instruments issued by state, city or country to finance its capital expenditures. It is issued by Government body to raise capital for construction of various projects.Interest income received from municipal bonds are generally exempted from federal income tax. So, in our given question,municipal bond which pays an interest rate of 7.9 percent per year is the after tax rate of interest received from municipal bonds.

Bond issued by ABC Corp.

Bond issued by ABC Corp. are not tax exempt. An investor need to pay 15% tax on interest income received from Bond.

Before tax Interest rate on bond from ABC Corp. = 9%

Tax rate = 15%

After tax interest on bond from ABC Corp = Before tax Interest rate*(1 - tax rate)

= 9%*(1- 0.15) = 9%*0.85 = 7.65%

So, we can see that from the above calculation, after tax interest on municipal bonds is 7.9% but after tax interest on corporate bond i.e. Bond issued by ABC Corp.is 7.65%. So, Municipal bonds will give the investor a higher after-tax interest rate.