Sally is choosing between two bonds both of which mature in 15 years and have the same level of risk. Bond A is a municipal bond that yields 5.25%. Bond B is a corporate bond that yields 7.75%. If Sally is in the 30% tax bracket, which bond should she select and why?
A) Sally should select Bond A because its interest income is not taxable.
B) Sally should select Bond B is better because it has lower risk.
C) Sally should select Bond A because its taxable equivalent yield is greater than the yield of Bond B.
D) Sally should select Bond B because the taxable equivalent yield of Bond A is less than the yield of Bond B.

Question

Quizplus · Accepted Answer

The taxable equivalent yield of Bond A is calculated as 5.25% / (1 - 0.30) = 7.50%. Since 7.50% is less than the 7.75% yield of Bond B, Bond B offers a higher after-tax return.

Sally Is Choosing Between Two Bonds Both of Which Mature