Question

A bank is considering two securities: a 30-year Treasury bond yielding 8 percent and a 30-year municipal bond yielding 3 percent. a. If the bank’s tax rate is 35 percent, calculate the Treasury bond's tax equivalent yield. (Round your answer to 1 decimal place. (e.g., 32.1)) b. Which bond offers the higher tax equivalent yield?

Answer 1

a. If the bank’s tax rate is 35 percent, calculate the Treasury bond's tax equivalent yield.

the bond's after tax yield = nominal yield x (1 - tax rate) = 8% x (1 - 35%) = 8% x 0.65 = 5.2%

b. Which bond offers the higher tax equivalent yield?

the treasury bond offers a higher yield 5.2% than the municipal bond (3%) even after calculating income taxes. Interests earned by municipal bonds are not taxed by the federal government.