Sally Is Choosing Between Two Bonds Both of Which Mature

question 87

Multiple Choice

Sally is choosing between two bonds both of which mature in 15 years and have the same level of risk. Bond A is a municipal bond that yields 5.75%. Bond B is a corporate bond that yields 7.75%. If Sally is in the 28% tax bracket, which bond should she select and why?

• A) Sally should select Bond A because its interest income is not taxable.
• B) Sally will be indifferent between Bond A and B since the taxable equivalent yield of Bond A equals the yield of Bond B.
• C) Sally should select Bond A because its TEY is greater than the yield of Bond B.
• D) Sally should select Bond B because the TEY of Bond A is less than the yield of Bond B.

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Definitions:

Financial Solvency

The ability of an entity to meet its long-term financial obligations, indicating a stable and viable fiscal position.

M&M Proposition I

A theory proposed by Modigliani and Miller that, in a perfect market, the value of a firm is unaffected by how it is financed, whether through debt or equity.

Capital Structure

The mix of different types of debt and equity a company uses to finance its operations.

Tax

Mandatory financial charges or some other type of levy imposed upon a taxpayer by a governmental organization in order to fund government spending and various public expenditures.