Tax Equivalent Yield Formula (Table of Contents)
- Tax Equivalent Yield Formula
- Tax Equivalent Yield Calculator
- Tax Equivalent Yield Formula in Excel (With Excel Template)
Tax Equivalent Yield Formula
The minimum pretax yield a particular bond should possess so that it makes equal to the return on tax-exempt investment. Taxable equivalent it is vastly used during the calculation of bond yield.
This calculation is extensively used for comparing the field of tax free Bond with a taxable Bond to see which of them has a higher yield. This calculation is also called after tax yield.
This yield return is calculated before investing in a Bond may it Corporate or Municipal. Thus as per the risk taking ability, the investors decide the particular bond scheme.
Tax Equivalent Yield Formula is:
Where:
- R (te) = taxable equivalent yield for the investor
- R (tf) = return on tax-free investment (usually a municipal bond)
- t = investor’s marginal tax rate
The tax equivalent yield formula is widely used to determine investment in a municipal Bond and if it is equivalent to its corresponding investment in that given taxable Bond. On the other hand in case of different tax bracket of a particular investor this calculation is very helpful in taking wise is investment decisions.
Examples of Tax Equivalent Yield Formula
Let us assume there are two investors – Investor A and Investor B.
Investor A falls in 28 percent tax bracket where is invested B like a tax bracket of 20 does use the tax equivalent yield formula we can make sure whether a municipal Bond with interest rate of 10% per annum would be beneficial for investor A or invested B?
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Tax Equivalent Yield for Investor A is Calculated as:
- R(te) = R(tf) / (1 – t)
- R (te) = 0.10 / (1 – 0.28)
- R (te) = 0.10 / 0.72
- R (te) = 0.1389 or 13.89%
Thus the taxable bond in case of Investor A must contain a yield greater than 13.89%, which would eventually be more profitable after deducting his 28% tax bracket. In other words, if the yield rate is 13.89%, the investor has would gain nothing out of the yield because of the 28% tax slab.
Tax Equivalent Yield for Investor B is Calculated as:
- R(te) = R(tf) / (1 – t)
- R (te) = 0.10 / (1 – 0.20)
- R (te) = 0.10 / 0.8
- R (te) = 0.125 or 12.5%
Investor B gets a yield of 12.5% per annum with a tax bracket of 20%
Explanation
Thus the taxable bond in case of Investor B must contain a yield greater than 12.5%, which would eventually be more profitable after deducting his 20% tax bracket.
In the case of Investor A, a taxable bond would give a return more than +13.89% to become more favorable than the 10% municipal bond. On the other hand, as Investor B has a lower tax bracket, he would get higher than +12.5% from the taxable municipal bond which tends to be more favorable than the same 10% municipal bond.
Significance and Use of Tax Equivalent Yield Formula
The major benefits of tax free yields are as follows:
- A profitable yield which is higher than the tax rate ensures a reliable stream of regular income through interest payments from municipal bonds.
- A properly tax equivalent yield adjust inflation and stables the value of the entire portfolio without taking any market risk.
- In between corporate bonds and municipal bonds, there are some differences.
- Unlike corporate bonds, the interest income from municipal bonds is always exempted from taxes. Thus to determine interest income which is exempted from taxes that is income from municipal bonds, and the interest income which is taxable that is income from corporate bonds we have to calculate with the help of tax equivalent yield calculation.
- Thus with the help of this app of formula one can identify the best suitable element for his portfolio
There are different financial instruments through which capital can be issued such as corporate bonds and municipal bonds.
Corporate bonds are generally issued by business entities where else municipal bonds generally public projects for public services.
Thus, capital required for both business and public services are generally offered to the public in the form of debt instruments.
Municipal bonds give low return compared to corporate bonds but have tax exemption, unlike corporate bonds.
Thus an investor with low-risk bearing capacity and with high tax bracket wood considers municipal bonds over corporate bonds.
Though, the choice may vary from investor to investor depending on the requirement and there risk taking abilities.
In case of a liquid fund or debt market, there are several heels available as per the coupon rate and the current market scenario.
Does an investor should be aware of he is tax rate and the rate of return he is getting out of his investments in bonds. So in case of taking investment decision, one has to consider several points such as tax rate bond yield and interest rate.
Certain exemptions on specific bonds allow investors to save money after investing a lump sum to that particular Bond.
Tax Equivalent Yield Formula Calculator
You can use the following Tax Equivalent Yield Calculator
| Tax Free Bond Yield | |
| Tax Rate | |
| Tax Equivalent Yield = | |
| Tax Equivalent Yield = |
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Tax Equivalent Yield Formula in Excel (With Excel Template)
Here we will do the same example of the Tax Equivalent Yield formula in Excel. It is very easy and simple. You need to provide the two inputs i.e Tax Free Bond Yield and Tax Rate
You can easily calculate the Tax Equivalent Yield using Formula in the template provided.
Tax Equivalent Yield for Investor A is Calculated Using Formula
Tax Equivalent Yield for Investor B is Calculated Using Formula
Conclusion – Tax Equivalent Yield Formula
We know that an investor goes through different ratings and purpose of taxable bonds before investing into that project. Apart from this, the investor has to take into account on the credit rating measures which the bond has given.
Another word it determines the risk associated with the bond. The higher the risk the more the interest of Bond. Thus it will be foolish to assume that a higher coupon rate Bond would be less risky. Thus taking everything into account such as coupon rate, discount rate, tenure and tax rate the investor has to decide whether the bond is actually suitable for him or not.
Tax equivalent yield formula help us to determine whether the interest income is profitable after deducting the tax percentage of that particular investor or not?
Meaning of the individual investors and as well as corporate determine their way of investment after calculating the final ILD from their born in coming years.
This is one of the major procedure through which the systematic risk and risk free return from the investment is calculated in case of a business order in case of an individual.
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