Series 7 practice questionhardTax Implications — Tax-Equivalent Yield
An investor in the 37% federal tax bracket is considering a municipal bond yielding 4.00%. A comparable corporate bond yields 6.25%. Which bond provides a better after-tax return?
- AThe municipal bond, with a tax-equivalent yield of 6.35%✓ Correct answer
- BThe corporate bond, with an after-tax yield of 4.50%
- CThey provide identical after-tax returns
- DThe corporate bond, with an after-tax yield of 3.94%
Explanation
Why A — The municipal bond, with a tax-equivalent yield of 6.35%
Municipal bond tax-equivalent yield = 4.00% / (1 - 0.37) = 4.00% / 0.63 = 6.35%. Corporate bond after-tax yield = 6.25% x (1 - 0.37) = 6.25% x 0.63 = 3.94%. The municipal bond's tax-equivalent yield of 6.35% exceeds the corporate bond's 6.25%, making the municipal bond more attractive on an after-tax basis for this high-bracket investor.
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