1. You are considering investing in a bond. Two opportunities present themselves
ID: 1172988 • Letter: 1
Question
1. You are considering investing in a bond. Two opportunities present themselves: municipal (tax-exempt) and corporate (taxable). Assume you pay 40% tax on any earnings and your MARR is 8%.
Municipal Corporate
i. Face Value $5000 $5000
ii. Market Price $3770 $2010
iii. Annual Interest 6% 10%
iv. Maturity 10 years 10 years
What is the better choice?
You are considering investing in a bond. Two opportunities present themselves: municipal (tax-exempt) and corporate (taxable). Assume you pay 40% tax on any earnings and your MARR is 8%. What is the better choice?Explanation / Answer
Taking into consideration the tax rates.
Annual Earning After tax in both the bonds are Rs.300
but going from the Capital Gain point of View
In case of Municipal Bond- Redemption Value will be 5000 post tax
whereas in case of Corporate bond- Redemption Value will be (5000-{5000-2010)*0.4 i.e. Rs.3804.
Now lets compare the bonds according to the Rate of Return hidden in the Bonds due to the Capital Gain
Municipal Bond's IRR is approximately equal to 10% while Corporate Bond's IRR is approximately equal to 18%.(IRR is computed by making Inflow=Outflow at a particular rate of return).
So Corporate Bond is better than Municipal Bond.
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