Question

The Carey State Bank has purchased a bank-qualified municipal bond with a yield of 6%. This bank has had to borrow funds to make this purchase at a cost of 5.35%. This bank is in the 40% tax bracket. What is the net after-tax return on this bank-qualified municipal bond? Under IRS rules if a muni bond is bank qualified then 80% of the interest expense associated with funding the investment is tax deductible.

A. 2.43%
B. None of the other responses are correct.
C. 2.36%
D. 6.00%
E. 2.85%

Answer 1

The Carey State Bank's net after-tax return on the municipal bond, after considering the yield, cost of borrowing, and tax benefits, is approximately 2.79%. The closest answer choice given is 'none of the other responses are correct.'

Step-by-step explanation:

The net after-tax return on the Carey State Bank's bank-qualified municipal bond can be calculated by considering both the interest earned from the bond and the tax benefits of borrowing costs. Since the bond yields 6% and bank funds were borrowed at a cost of 5.35%, the first step is to determine the net interest return. However, the cost of borrowing is not fully felt, as 80% of the interest expense is tax-deductible for a bank-qualified municipal bond. This means the bank can deduct 80% of the 5.35% interest expense from its taxable income. Being in the 40% tax bracket effectively reduces the borrowing costs and impacts the overall return.

To calculate the adjusted borrowing cost: 0.803030.803035.35% * (1 - 40% tax relief) = 3.21%. Now, we deduct the adjusted borrowing cost from the yield of the bond: 6% - 3.21% = 2.79%. This is an approximation to find the answer, which will be the closest to the provided options. Since none of the options exactly match our calculation, the correct choice would be the one that is none of the other responses are correct.