Final answer:
The student's question involves calculating the taxable equivalent yields of tax-free bonds to compare different investment returns based on the investor's tax bracket, considering both the tax-free yield of the bonds and the individual's tax rate.
Step-by-step explanation:
The student's question pertains to how to calculate the taxable equivalent yields of tax-free bonds based on an investor's tax bracket, in order to compare them to taxable investments. This calculation factors in the investor's tax rate and the tax-free yield of the bond.
When calculating the yield on a bond, you need to consider not just the coupon rate but also the total return which includes capital gains or losses from the sale of the bond. For instance, if you purchase a bond for $964 and the face value is $1,000 you will earn not only the 8% coupon payment but an additional return due to the bond's increase in value to its face value at maturity.
The formula for calculating the taxable equivalent yield is given by taking the tax-free yield of a bond and dividing it by 1 minus the investor's marginal tax rate. Ordering investments from least to greatest return should be done after all taxable equivalent yields have been calculated.
Example:
An investor in the 20% tax bracket has a tax-free bond yielding 5%. The taxable equivalent yield is therefore 5% / (1 - 0.20) = 6.25%. This means for an investor in the 20% tax bracket, a taxable bond would need to yield more than 6.25% to be considered a better investment than the tax-free bond.