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 5.75 percent. Bond B is a corporate bond that yields 7.75 percent. If Sally is in the 28 percent tax bracket, which bond should she select and why?
A) Sally should select Bond A because its interest income is not taxable.
B) Sally will be indifferent between Bond A and B since the taxable equivalent yield of Bond A equals the yield of Bond B.
C) Sally should select Bond A because its TEY is greater than the yield of Bond B.
D) Sally should select Bond B because the TEY of Bond A is less than the yield of Bond B.

Question

Quizplus · Accepted Answer

To determine the better option, we calculate the Taxable Equivalent Yield (TEY) of the municipal bond (Bond A) using the formula: TEY = Tax-Exempt Yield / (1 - Tax Rate). For Bond A, TEY = 5.75% / (1 - 0.28) = 7.986%. Since 7.986% is greater than Bond B's yield of 7.75%, Sally should select Bond A because its TEY is greater than the yield of Bond B.

Sally Is Choosing Between Two Bonds Both of Which Mature