Yields of a Bond A 3.25 percent coupon municipal bond has 12 years left to maturity and has a price quote of 98.75.The bond can be called in five years.The call premium is one year of coupon payments.What is the bond's taxable equivalent yield for an investor in the 35 percent marginal tax bracket? (Assume interest payments are paid semi-annually and a par value of $5,000.)

Question

Quizplus · Accepted Answer

First, we need to calculate the bond's yield to maturity using the given information:

PV = $98.75 x $50 = $4,937.50
Coupon payment = 3.25% x $5,000 / 2 = $81.25
N = 12 x 2 = 24
FV = $5,000

Using a financial calculator or Excel, we get the yield to maturity (YTM) as 3.46%.

Next, we need to calculate the yield to call assuming the bond is called in 5 years:

PV = $98.75 x $50 = $4,937.50
Coupon payment = 3.25% x $5,000 / 2 = $81.25
N = 5 x 2 = 10
FV = $5,000
Call premium = 1 year of coupon payments = $162.50

PV = $4,937.50 + $81.25 x PVIFA(3.46%/2, 10) - $162.50
Using a financial calculator or Excel, we get the yield to call (YTC) as 5.21%.

Finally, we calculate the taxable equivalent yield (TEY) for an investor in the 35% marginal tax bracket:

TEY = YTC / (1 - tax rate)
TEY = 5.21% / (1 - 0.35)
TEY = 8.02%

Therefore, the best choice is C) 5.20%.

Yields of a Bond a 3