ExpertMedium1 markMultiple Choice
CPA · Question 17 · Area I: Individual Compliance and Planning
A taxpayer in the 35% marginal tax bracket is comparing two bonds: <br/>1. Corporate Bond yielding 6%.<br/>2. Municipal Bond (tax-exempt) yielding 4%.<br/>Which bond provides the higher after-tax return?
A taxpayer in the 35% marginal tax bracket is comparing two bonds: <br/>1. Corporate Bond yielding 6%.<br/>2. Municipal Bond (tax-exempt) yielding 4%.<br/>Which bond provides the higher after-tax return?
Answer options:
A.
Corporate Bond (3.9% after-tax)
B.
Municipal Bond (4.0% after-tax)
C.
Corporate Bond (6.0% after-tax)
D.
Both are equal.
How to approach this question
Calculate Tax Equivalent Yield or After-Tax Yield. After-Tax Yield of Corp Bond = 6% * (1 - 0.35) = 3.9%. Muni Bond = 4%. 4% > 3.9%.
Full Answer
B.Municipal Bond (4.0% after-tax)✓ Correct
B
After-tax return on Corporate Bond = Pre-tax yield × (1 - Tax Rate) = 6% × (1 - 0.35) = 3.9%. The Municipal Bond yields 4% tax-free. The Municipal Bond is superior.
Common mistakes
Comparing the raw yields (6% vs 4%) without adjusting for tax.
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