You have the opportunity to buy a zero coupon municipal bond that will pay you $
ID: 2721709 • Letter: Y
Question
You have the opportunity to buy a zero coupon municipal bond that will pay you $1000 in three years. The current market yield to maturity on this bond is 4.7%. What price should you pay for the bond today? What will the bond be worth a year from today assuming the market yield to maturity remains at 4.7%? Given that you are in the 45 percent combined federal and state tax rate, what is your tax-equivalent yield on the bond? In other words, what rate would a zero coupon taxable bond need lo yield before taxes if it were to have a 4.7 percent after-tax yield?Explanation / Answer
Face value of bond = $1,000
Year to maturity = 3 year
Current market rate = 4.7%
Current price of bond = $1,000 / (1 + 4.7%) ^3
= $1,000 / 1.1477
= $871.28
Hence Current Price of bond is $871.28.
After one year number of year remains in maturity is 2 year and market rate remains at 4.7%.
So price of bond after one year = $1,000 / (1 + 4.7%) ^2
= $1,000 / 1.0962
= $912.23
Hence, Price of bond after one year will be $912.23.
Tax rate = 45%
Yield on bond = 4.7%
Tax equivalent yield on bond = 4.7% / (1 - 45%)
= 8.55%
Hence, Tax equivalent yield on bond is 8.55%.
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