Question

Maria is a wealthy investor who’s looking for a tax shelter. Maria is in the maximum (35%) federal tax bracket and lives in a state with a very high state income tax. (She pays the maximum of 10% in state income tax.) Maria is currently looking at two municipal bonds, both of which are selling at par. One is a AA-rated, in-state bond that carries a coupon of 6%. The other is a AA-rated, out-of-state bond that carries a 7% coupon. Her broker has informed her that comparable fully taxable corporate bonds are currently available with yields of 10%.

a. What are the tax-adjusted yields of the two municipal bonds?

b. Which one of the three bonds should she buy?

Answer 1

Now we will calculate yield of all bonds

Own state bond carries 6% yield as it is own state it is not taxable

Other state municipal bond. In this bond she has to pay state tax which is 10%

So ofter tax yield is 7(1-0.1) =6.3%

She has to pay 45% tax on coorperate bond (35federal plus 10 state)

After tax yield is 10(1-0.45) =5.5%

a) yeild of home state municipal is 6

Yield other state municipal bond is 6.3%

b) she should invest in other state municipal bond as yield (6.3%) is higher than all bonds