Suppose you’re evaluating three alternative MMMF investments. The first fund buy

Question

Suppose you’re evaluating three alternative MMMF investments. The first fund buys a diversified portfolio of municipal securities from across the country and yields 4.0 percent. The second fund buys only taxable, short-term commercial paper and yields 5.9 percent. The third fund specializes in the municipal debt from the state of New Jersey and yields 3.7 percent. Your federal income tax rate is 35 percent and you are a resident of Texas, which has no state income tax. a. Calculate the after-tax yield for each of the alternatives.

Explanation / Answer

First fund buys a diversified portfolio of municipal securities that have yield of 4%.

Municipal securities are exempt from Federal income taxes.

So,

The after-tax yield from dicersified portfolio of municipal securities would be 4 percent.

Second fund buys only taxable, short-term commercial paper that have yield of 5.9 percent.

Federal income tax rate is 35 percent.

After-tax yield = Before-tax yield * [1 - federal income tax rate]

After-tax yield = 5.9 * (1-0.35) = 3.81%

So,

The after-tax yield from taxable, short-term commercial paper is 3.81 percent.

Third fund buys municipal debt from the state of New Jersey that have yield of 3.7%.

Municipal bonds are exempt from the Federal income taxes.

So,

The after-tax yield from municipal debt from the State of New Jersey is 3.7 percent.

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