Question

Janice Wilcox is a wealthy investor who's looking for a tax shelter. Janice is in the maximum (37%) federal tax bracket and lives in a state with a very high state income tax. (She pays the maximum of 12.3% in state income tax.) Janice is currently looking at two municipal bonds, both of which are selling at par. One is a AA-rated in-state bond that carries a coupon of 7.934%. The other is a AA-rated, out- of-state bond that carries a coupon of 8.639%. Her broker has informed her that comparable fully taxable corporate bonds are currently available with yields of 11.076%. Alternatively, long Treasuries are now available at yields of 10.498%. She has $100,000 to invest, and because all the bonds are high-quality issues, she wants to select the one that will give her maximum after-tax returns. a. Which one of the four bonds should she buy? b. Rank the four bonds (from best to worst) in terms of their taxable equivalent yields. a. The taxable equivalent yield on the in-state municipal bond is %. (Round to three decimal places.) The taxable equivalent yield on the out-of-state municipal bond is %. (Round to three decimal places.) The taxable equivalent yield on the corporate bond is %. (Round to three decimal places.) The taxable equivalent yield on the Treasury bond is %. (Round to three decimal places.) Which one of the 4 bonds should she buy? (Select the best choice below.) O A. Janice should buy the corporate bond that has a yield of 11.076%; its higher taxable equivalent yield means it has the highest after-tax return. O B. Janice should buy the AA-rated out-of-state bond that has a yield of 8.639%; its higher taxable equivalent yield means it has the highest after-tax return. O C. Janice should buy the Treasury bond that has a yield of 10.498%; its higher taxable equivalent yield means it has the highest after-tax return. O D. Janice should buy the AA-rated in-state bond that has a yield of 7.934%; its higher taxable equivalent yield means it has the highest after-tax return. Click to select your answer(s).

Answer 1

In the case of municipal bond the income would be first taxable at federal level and then the remaining income would be taxable at state level so taxable equivalent yield = Municipal bond yield/(1-(federal tax rate+ state tax rate*(1- federal tax rate))) State bond So tax equivalent yield = 7.934/(1-(0.37+0.123*(1-0.37))) 14.360 Out of state bond would be exempted from federal tax Taxable equivalent yield = municipal yield/(1-federal tax rate) 8.639/(1-0.37) 13.713 Coporate bonds are taxable so = 11.08% Long term treasuries are taxed at federal level but not at tax level tax equivalent yield = tresury yield/(1- state level tax) 10.498/(1-0.123) 11.970 Best option would be highest tax equivalent yield (In state bond, Out of state bond, long term treasury, corporate bond) Janice should by the AA-rated in state bond that has a yield of 7.934%, its higher taxable equivalent yield means it has highest after tax return