Question

Hugh has the choice between:

City of Heflin bond at 6 percent [non-taxable]
Surething bond at 9 percent [taxable]
Assume that both bonds have the same nontax characteristics
Hugh has a 40 percent marginal tax rate, in which bond should he invest?

Answer 1

Given Hugh's 40 percent marginal tax rate, the after-tax return of the Surething bond is 5.4%. As this is lower than the 6% return of the tax-exempt City of Heflin bond, the Heflin bond is the better investment for Hugh.

Step-by-step explanation:

The decision on whether Hugh should invest in the City of Heflin bond at 6 percent [non-taxable] or the Surething bond at 9 percent [taxable] depends on the after-tax yield of the taxable bond. With a 40 percent marginal tax rate, the taxable equivalent yield of the Heflin bond can be calculated. To determine the better investment, we compare the after-tax return of the Surething bond to the return of the Heflin bond.

The after-tax return (ATR) on the Surething bond is calculated as follows:

ATR = Interest Rate × (1 - Tax Rate)

ATR = 9% × (1 - 0.40) = 5.4%

Because the after-tax return of the Sure thing bond (5.4%) is lower than the return on the Heflin bond (6%), Hugh should invest in the City of Heflin bond as it yields a higher effective return given his tax situation.