Question

2. Bond Investment Recommendation (6 pts.) Suppose that you are a financial advisor to two individuals who are considering investing in either a taxable Corporate Bond with an interest rate of 7.25%, or a federal tax-exempt Municipal Bond with a rate of 5.12%. Assume that both bonds have the same default risk and that, given their respective levels of income, one of the investors, Ms. Benson, is subject to a marginal income tax rate of 39%, while the other investor, Mr. Zambrano, pays a marginal income tax rate of 22%. Which bond would you recommend to each of these two investors? Why? Please show your calculations.

Answer 1

To recommend a bond, we need to calculate the after-tax rate of the corporate bond for each investor. The municipal bond is tax exempt, and hence its after-tax rate equals its pretax rate.

After-tax rate = pretax rate * (1 - tax rate)

Benson

After-tax rate on corporate bond = 7.25% * (1 - 39%) = 4.42%.

After-tax rate on municipal bond = 5.12%.

The municipal bond is recommended as it has a higher after-tax rate for Mr. Benson.

Zambrano

After-tax rate on corporate bond = 7.25% * (1 - 22%) = 5.66%.

After-tax rate on municipal bond = 5.12%.

The corporate bond is recommended as it has a higher after-tax rate for Mr. Zambrano.