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Series 7 practice questionmediumTax Implications — Tax-Equivalent Yield

An investor in the 32% federal tax bracket is comparing a municipal bond yielding 3.5% to a corporate bond. What is the tax-equivalent yield of the municipal bond?

  1. A4.38%
  2. B5.15%✓ Correct answer
  3. C4.86%
  4. D5.50%
Explanation

Why B — 5.15%

Tax-equivalent yield = Municipal yield / (1 - Tax rate) = 3.5% / (1 - 0.32) = 3.5% / 0.68 = 5.15%. This means a corporate bond would need to yield at least 5.15% before taxes to provide the same after-tax return as the 3.5% tax-exempt municipal bond. The higher the investor's tax bracket, the more attractive municipal bonds become on a tax-equivalent basis.

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