Banking Practice Exam

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A municipal bond with a tax-exempt rate of 6.5% and a marginal tax rate of 40% yields which of the following taxable equivalent yields?

3.90%

10.83%

To determine the taxable equivalent yield of a tax-exempt municipal bond, you can use the formula:

Taxable Equivalent Yield = Tax-Exempt Yield / (1 - Marginal Tax Rate)

In this case, the tax-exempt yield is 6.5%, and the marginal tax rate is 40%, which translates to 0.40 in decimal form.

Plugging in the numbers:

Taxable Equivalent Yield = 6.5% / (1 - 0.40)

Taxable Equivalent Yield = 6.5% / 0.60

Taxable Equivalent Yield = 10.8333%

When rounded, this value corresponds closely to 10.83%.

This calculation illustrates how much equivalent yield a taxpayer in the 40% tax bracket would need to earn on a taxable investment to match the after-tax return of a municipal bond. Given the high marginal tax rate, the taxable equivalent yield is significantly higher than the tax-exempt rate, demonstrating the advantage of municipal bonds for investors in higher tax brackets. Thus, the correct taxable equivalent yield for the bond is 10.83%.

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9.10%

4.64%

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