Question

You can invest in either corporate bonds which yield 4.18%, or municipal bonds (of equal risk) which yield 3.09%.  Which investment should you choose for cases A and B?

Ignore state income taxes:

         A. Your personal tax rate is 35%

B. Your personal tax rate is 14%

Answer 1

In order to check the best available alternative, we need to compare the post tax yield on corporate bond to yield on municipal bond.

Yield on Municipal bond = 3.09%

Pretax yield on Corporate bond = 4.18%

a) Income tax Rate = 35%

Post tax corporate bond yield = 4.18% * (1 - 35%) = 2.72%

This is less than 3.09% earned on a Municipal bond. Hence choose Municipal Bond.

b) Income tax Rate = 14%

Post tax corporate bond yield = 4.18% * (1 - 14%) = 3.59%

This is more than 3.09% earned on a Municipal bond. Hence choose Corporate Bond.