Investor A’s marginal tax rate is 45%, while Investor B’s is 30%. Both investors are considering two bonds for inclusion in a taxable portfolio. One bond is tax-exempt with a yield of 4.50%, while the other is taxable with a yield of 6.30%. Which bond will each investor most likely choose?
B is correct because the after-tax yield of the taxable security is lower than the yield on the tax exempt security for both investors. After-tax yield = Pretax yield × (1 – Marginal tax rate). For Investor A, the After-tax yield = 6.30% × (1 - 0.45) = 3.47%. For Investor B, the After-tax yield = 6.30% × (1 - 0.30) = 4.41%. Both are less than 4.50% and the investor will choose the investment with the highest after-tax yield.