Future Business Leaders of America (FBLA) Securities and Investments Practice Test

What is tax equivalent yield used to calculate?

1. The yield of a taxable bond to equal a tax-exempt yield

2. The interest rate of a revenue bond

3. The risk level of municipal bonds

4. The return on investment for corporate stocks

The correct answer is: The yield of a taxable bond to equal a tax-exempt yield

Tax equivalent yield is a calculation used to determine the yield on a taxable investment that would provide the same after-tax income as a tax-exempt investment, such as a municipal bond. It essentially allows investors to compare the potential returns of taxable and tax-exempt securities on an equal footing, factoring in the investor's tax bracket. This is particularly relevant for those in higher tax brackets who may benefit more from tax-exempt investments, as the tax-exempt yield can sometimes be more advantageous despite a lower nominal yield. For example, to accurately compare a municipal bond that is tax-exempt with a corporate bond that is taxable, an investor would use the tax equivalent yield formula. By doing this, the investor can ascertain whether the after-tax benefits of the tax-exempt bond outweigh the potential returns of the taxable bond. This calculation helps in making informed investment decisions, ensuring that one considers both the nominal yield and the tax implications associated with different investment options.