Question

You are trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are the same and you are in the 28% tax bracket, which bond should you choose and why?
A.
Corporate bond because the after tax yield is 6.25%.

B.
Corporate bond because the after tax yield is 4.5%.

C.
Municipal bond because the equivalent taxable yield is 6.3%.

D.
Municipal bond because the equivalent taxable yield is 6.6%.

E.
You will be indifferent between the two because the after tax yields are the same.

Answer 1

Answer:

D.

Municipal bond because the equivalent taxable yield is 6.6%

Explanation:

we should make the important difference that municipal bonds are tax free while corporate bonds don't.

Therefore we should solve for the after tax rate fo the corporate bond:

$pretax (1-t) = after tax -rate\\0.0625(1-0.28) = 0.0625(0.72) = 0.045$

The corporate bond as a yield of 4.5% after taxes which is lower than the municipal bond. This make it more attractive

We can also solve for the pre-tax rate of the municipal bond:

$pretax(1-t) = after tax - rate\\pretax (1-0.28) = 0.0475\\pretax = 0.0475/0.72 = 0,065972 = 0.066$

the municipal bonds would be equivalent to a 6.6% corporate bonds.

This makes option D correct.