Question

An investor in the 28% tax bracket purchases a municipal bond with a 7.2% tax-free yield. What fully taxable return must the investor receive on a corporate bond to receive the same after-tax return?

a. 7.2%
b. 10%
c. 25.7%
d. 28%

Answer 1

To achieve the same after-tax return, the investor must receive a fully taxable return of approximately 7.2% on a corporate bond.

Step-by-step explanation:

To calculate the fully taxable return the investor must receive on a corporate bond to achieve the same after-tax return as the tax-free yield of the municipal bond, we can use the after-tax yield equation. The after-tax yield is calculated by subtracting the tax rate from 100% and then multiplying it by the tax-free yield. In this case, the investor is in the 28% tax bracket, so the after-tax yield is (100% - 28%) x 7.2% = 5.184%.

To determine the fully taxable return on a corporate bond, we can set up the equation: (1 - tax rate) x fully taxable return = after-tax yield. Plugging in the values, we get (1 - 28%) x fully taxable return = 5.184%. Solving for the fully taxable return, we find that it is approximately 7.2%, which corresponds to option a.