6. Determine the annual return rate on a 12-year, $15,000 discount bond that you

Question

6. Determine the annual return rate on a 12-year, $15,000 discount bond that you originally purchased for $6,200 sold 7 years later for $9,100. 7. Suppose that you are a saver with a choice of three financial assets that are identical in every way except their nominal interest rate and taxability. Calculate the after tax real yield for each of the following three assets and choose which of the three assets is the best option if inflation is expected to be 1.75% annually with a federal income tax rate of 26%. Asset 1 : Asset 2: Asset 3: A corporate bond with an interest rate 7.5% in a state with an income tax rate of4.5%. A Treasury bond with an interest rate 6.25% in a state income tax rate of 0%. A municipal bond with an interest rate 5.0% in a state with an income tax rate of 5.5%.

Explanation / Answer

Real after tax yield for asset 1

Total tax for corporate bond =26%+4.5%=30.5%

Hence after tax nominal yield is 69.5%

Real tax yield is

(7.5%)*69.5%/1.0175=7.5%*0.646=4.85%

Similar for Asset 2

Total tax=26%

After tax rate=0.74%

Real Yield after tax=6.25%*0.74%/(1.0175)=6.25%*0.73%/1.0175=4.4840%

Similar for Asset 3

Tax =31.5%

After tax yield=5%*(1-31.5%)=5%*0.685=3.425%

Real yield after tax=3.425%/(1.0175)=3.37%

Asset 1 yields higher payoff hence asset 1 to be chosen

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