Question

Joe is considering 2 similar bonds, with the only difference that: (1) a tax-exempt municipal bond promises a 5.625% annual return, (2) a taxable corporate bond promises a 7.5% annual return. If Joe's tax rate is 25%, which bond should he buy?

a. Either one, both have the same after-tax yield
b. Municipal bond, as it has a higher after-tax yield
c. Corporate bond, as it has a higher after-tax yield
d. Not enough information is given to answer the question

Answer 1

a. Either one, both have the same after-tax yield

Step-by-step explanation:

we have to calculate the after tax return of the bonds:

after tax return of corporate bonds = bond yield x (1 - tax rate) = 7.5% x (1 - 25%) = 7.5% x 0.75 = 5.625%

since municipal bonds are not included as part of Joe's gross income, their after tax rate is equal to their yield = 5.625%

both bonds yield the same after tax return = 5.625%