Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on thirty-year U.S. Treasury bonds is 10%. You would be indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of
A)6.5%.
B)7.0%.
C)9.5%.
D)10.0%.

Question

Quizplus · Accepted Answer

To calculate the after-tax yield of a municipal bond, you need to subtract the tax savings from your marginal tax rate from the bond's yield:

After-tax yield = (1 - marginal tax rate) × municipal bond yield

In this case,

After-tax yield = (1 - 0.30 - 0.05) × municipal bond yield 
After-tax yield = 0.65 × municipal bond yield

To be indifferent between a Treasury bond with a 10% yield and a municipal bond with an after-tax yield of Y, we need to set them equal:

10% yield on Treasury bond = 0.65 × municipal bond yield

Solving for the municipal bond yield, we get:

Municipal bond yield = (10% yield on Treasury bond) / 0.65 
Municipal bond yield = 15.38%

Therefore, you would be better off buying the Treasury bond unless the municipal bond yield is greater than 15.38%. Since none of the answer choices are greater than 15.38%, the best choice is B (7.0%), which has the highest yield among the answer choices.

Suppose That Your Marginal Federal Income Tax Rate Is 30