Question

Emily is in the 35% marginal tax bracket. She can purchase a York County school bond yielding 3.5% interest, which is not subject to a 5% state tax. But she is interested in earning a higher return for comparable risk. Which of the following is correct:

a) If she buys a corporate bond that pays 6% interest, her after-tax rate of return will be less than if she had purchased the York County school bond.
b) If she buys a U.S. government bond paying 5%, her after-tax rate of return will be less than if she had purchased the York County school bond.
c) If she buys a common stock paying a 4% dividend, her after-tax rate of return will be higher than if she had purchased the York County school bond.
d) All of these are correct.
e) None of these is correct.

Answer 1

The correct answer is that if Emily buys a U.S. government bond paying 5%, her after-tax rate of return will be less than if she had purchased the York County school bond. The corporate bond at 6% and the common stock at 4% both offer higher or comparable after-tax yields than the school bond. Option b.

Step-by-step explanation:

When Emily, who is in the 35% marginal tax bracket, considers her options between tax-exempt bonds and taxable bonds or stocks, she needs to calculate the after-tax yield to make an accurate comparison. Let's analyze each option to determine the correct choice.

A.) For a corporate bond that pays 6% interest, her after-tax return would be 6% * (1 - 0.35) = 3.9%. Since the York County school bond yields 3.5% interest tax-free, the corporate bond offers a higher after-tax yield, making statement a) incorrect.

B.) If she buys a U.S. government bond paying 5%, her after-tax return would be 5% * (1 - 0.35) = 3.25%. This is less than the York County school bond's yield, making statement b) correct.

C.) Dividend taxes vary, but assuming the same marginal tax rate applies, for a stock paying a 4% dividend, her after-tax return would be 4% * (1 - 0.35) = 2.6%, which is lower than the York County school bond's yield. Therefore, statement c) is incorrect.

The correct answer, based on the after-tax yield calculations, is b) If she buys a U.S. government bond paying 5%, her after-tax rate of return will be less than if she had purchased the York County school bond. Options a) and c) offer higher or comparable after-tax yields, so neither can be correct.