Question

Question 1 (10 points) Dena is in the 10% federal income tax bracket and wants to invest $8,000 in interest-carning assets. Cullen is in the 35% bracket and wants to invest $15,000. The current rate on a typical high-quality tax-exempt municipal bond is 5% and on a similar quality corporate bond is 6.5%. You are the financial adviser to both. Which investment would you recommend to each individual?

Answer 1

after tax interest received by any individual on corporate bond = stated interest rate *(1-tax rate)

On municipal bonds there will not be any tax, so the stated interest will be the after tax interest to be received.

so,

Consider Dena

after tax interest on corporate bond to be received by Dena = 6.5% *(1-0.10) =>5.85%.

municipal bond interest to be received by Dena = 5%.

So Dena can consider investing in corporate bonds for higher returns.

consider Cullen

after tax interest on corporate bond to be received by Cullen = 6.5%*(1-0.35) =>4.225%.

municipal bond interest to be received by cullen = 5%.

so cullen can consider investing in municipal bond for higher returns.