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?
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
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