Question

You are making a decision to purchase either a 6-year corporate bond or a 6-year municipal bond. The corporate bond is a 11% annual coupon bond with a par value of $1,000. It is currently yielding 12%. The municipal bond has an 9.5% annual coupon and a par value of $1,000. It is currently yielding 7.5%. Which of the two bonds would be more beneficial to you? Assume that your marginal tax rate is 37%.

Answer 1

Answer :

Corporate Bond :

Current Yield = 12%

Marginal tax rate = 37%

Taxable equivalent yield = 12%/(1-0.37) = 19.05%

Variables

C = coupon payment = $110.00 (Par Value * Coupon Rate)

n = number of years = 6

i = market rate, or required yield = 19.050% = 0.19

k = number of coupon payments in 1 year = 1

P = value at maturity, or par value = 1000

Bond value = $725.86

Given the current market rate of 19.050% for a similar bond, a bond with a face value of $1,000.00 and paying a coupon rate of 11.000% (compounding annually), should be selling for $725.86 (selling at a discount).

End of Year	Interest	Principal	Present Value
1.00	$110.00		$92.40
2.00	$110.00		$77.61
3.00	$110.00		$65.19
4.00	$110.00		$54.76
5.00	$110.00		$46.00
6.00	$110.00		$38.64
6.00		$1,000.00	$351.26
		TOTAL	$725.86

Municipal Bond :

Current Yield = 7.5%

Marginal tax rate = 37%

Taxable equivalent yield = 7.5%/(1-0.37) = 11.90%

Variables

C = coupon payment = $95.00 (Par Value * Coupon Rate)

n = number of years = 6

i = market rate, or required yield = 11.900% = 0.12

k = number of coupon payments in 1 year = 1

P = value at maturity, or par value = 1000

Bond Value = $901.05

Given the current market rate of 11.900% for a similar bond, a bond with a face value of $1,000.00 and paying a coupon rate of 9.500% (compounding annually), should be selling for $901.05 (selling at a discount).

End of Year	Interest	Principal	Present Value
1.00	$95.00		$84.90
2.00	$95.00		$75.87
3.00	$95.00		$67.80
4.00	$95.00		$60.59
5.00	$95.00		$54.15
6.00	$95.00		$48.39
6.00		$1,000.00	$509.35
		TOTAL	$901.05

Which of the two bonds would be more beneficial to you - Therefore, it is clear that municipal bond will be more beneficial to you. (Higher bond valuation)