Marginal Tax rate on Municipal Bond - Pls someone explain?

girimpr
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Joined: Thu Nov 22, 2012 4:12 pm

Marginal Tax rate on Municipal Bond - Pls someone explain?

Postby girimpr » Sun Nov 25, 2012 12:31 am

Consider a corporate bond with a yield of 6.8% and a municipal bond (with equivalent risk) with a 4.9% yield. Which of the following statements is most accurate?

A) An investor with a marginal tax rate of 40% prefers the corporate bond.

B) The tax-equivalent yield for an investor with a 35% marginal tax rate is 7.32%.

C) An investor with a marginal tax rate of 28% is indifferent between the two bonds.


The correct answer was C) An investor with a marginal tax rate of 28% is indifferent between the two bonds.

An investor with a marginal tax rate of 28% has a tax-equivalent yield on the municipal bond of 6.8% and is, therefore, indifferent between the two bonds (of equivalent risk). As the marginal tax rate increases, the investor will prefer the municipal bond to the corporate bond. Note that with a marginal tax rate of 35%, the tax-equivalent yield for the municipal bond would be 4.9 / (1 − 0.35), or 7.54%.

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pankaj
Finance Junkie
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Joined: Fri Aug 03, 2012 11:24 am

Re: Marginal Tax rate on Municipal Bond - Pls someone explai

Postby pankaj » Mon Nov 26, 2012 2:58 pm

to compare municipal bond and corporate bond, you have to fist calculated the tax equivalent yield on the municipal bond (i.e. what would be the yield on the municipal bond is tax would have applied on the municipal bond).

Tax Equivalent yield = yield on the subject bond (i.e. municipal bond)/ (1- marginal tax rate applicable to the investor).

So, in the given case, tax equivalent yield on municipal bond comes to 6.8% and the yield on the corporate bond is also 6.8%. So, investor can invest in either of the bond. That is, if the investor invest in corporate bond, he/she will receive 6.8% yield but after paying his/her applicable marginal tax to the authority, he/she will left with a yield of 4.9% (equivalent to yield on municipal bond).

Hope this helps!

girimpr
Posts: 5
Joined: Thu Nov 22, 2012 4:12 pm

Re: Marginal Tax rate on Municipal Bond - Pls someone explai

Postby girimpr » Thu Nov 29, 2012 1:34 am

Thanks Pankaj!!!


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