Question

Ms. Z has decided to invest $75,000 in state bonds. She could invest in State A bonds paying 5 percent annual interest or in State R bonds paying 5.4 percent annual interest. The bonds have same risk , the interest from both is exempt from federal income tax. Because Ms. Z is a resident of State A , she would not pay State A's 8.5 percent personal income tax on the State A bond interest, but she would pay this tax on the State R bond interest .Ms. Z can deduct any State tax payments in the computations of her federal taxable income , and her federal marginal rate is 33 percent. Should Ms. Z invest in the State A or State R bonds?

Answer 1

To determine whether Ms. Z should invest in State A or State R bonds, we need to compare the after-tax yield of each bond. By calculating the after-tax yields using the given information, we find that the State R bond has a higher after-tax yield of 5.4% compared to the State A bond with an after-tax yield of 3.705%. Therefore, Ms. Z should invest in the State R bonds.

Step-by-step explanation:

To determine whether Ms. Z should invest in the State A or State R bonds, we need to compare the after-tax yield from each investment. Since Ms. Z is a resident of State A, she would not pay State A's 8.5% personal income tax on the State A bond interest. However, she would pay this tax on the State R bond interest. Additionally, Ms. Z can deduct any State tax payments in the computation of her federal taxable income, and her federal marginal rate is 33%.

To calculate the after-tax yield of each bond:

1. State A bond: Interest rate = 5%, Deductible State tax rate = 8.5%, Federal marginal tax rate = 33%
2. State R bond: Interest rate = 5.4%, Deductible State tax rate = 0%, Federal marginal tax rate = 33%

To calculate the after-tax yield for each bond, use the formula:

After-tax yield = (Interest rate - (Deductible State tax rate * Federal marginal tax rate))

1. State A bond: After-tax yield = (5% - (8.5% * 33%)) = 0.03705 or 3.705%
2. State R bond: After-tax yield = (5.4% - (0% * 33%)) = 0.054 or 5.4%

Comparing the after-tax yields, we can see that the State R bond has a higher after-tax yield of 5.4% compared to the State A bond with an after-tax yield of 3.705%. Therefore, Ms. Z should invest in the State R bonds.

Answer 2

Ms. Z should invest in the State A.

Step-by-step explanation:

Coupons from State A = (1 - 0.33)*0.05*75000

= 2512.5

Coupons from State R = (1 - 0.33 - 0.085)*.054*75000

= 2369.25

Therefore, Ms. Z should invest in the State A .