A client is considering investing in a municipal bond fund. They are in the 32% federal tax bracket and their state tax rate is 5%. The municipal bond fund yields 4.5%. A comparable corporate bond fund yields 6%. What is the tax-equivalent yield of the municipal bond fund, and which fund offers a better after-tax return for this client?

Correct answer: B. Tax-equivalent yield: 6.62%; Municipal bond fund offers a better after-tax return.

To calculate the tax-equivalent yield (TEY) for a municipal bond, use the formula: TEY = Municipal Bond Yield / (1 - Marginal Tax Rate). First, calculate the combined marginal tax rate: 32% (federal) + 5% (state) = 37%. Tax-equivalent yield = 4.5% / (1 - 0.37) = 4.5% / 0.63 = 7.14%. Wait, the options are based on federal tax only. Let's re-calculate assuming only federal tax exemption for municipal bonds, which is a common simplification unless state tax exemption is also explicitly stated or implied by 'in-state'. If only federal tax is exempt, then the combined tax rate for the corporate bond for comparison would be 32% + 5% = 37%. For the municipal bond, assuming it's only federally tax-exempt (and state tax applies if not in-state), the after-tax yield would be 4.5% * (1 - 0.05) = 4.275%. The corporate bond after-tax yield is 6% * (1 - 0.37) = 3.78%. In this case, the municipal bond is better. However, the question implies typical municipal bond treatment, which is often both federal and state tax-exempt if issued in the client's state. Assuming both federal and state tax exemption for the municipal bond: Combined marginal tax rate = 32% (federal) + 5% (state) = 37%. Tax-equivalent yield = 4.5% / (1 - 0.37) = 4.5% / 0.63 = 7.14%. This is not among the options. Let's assume the question implicitly refers to the federal tax rate only for the 'tax-equivalent yield' calculation, as is common in many quick calculations, or it assumes state tax also applies to the muni and only federal is exempt. If only federal tax is used for the TEY calculation: TEY = 4.5% / (1 - 0.32) = 4.5% / 0.68 = 6.617% or 6.62%. After-tax yield of corporate bond: 6% * (1 - 0.32 - 0.05) = 6% * (1 - 0.37) = 6% * 0.63 = 3.78%. After-tax yield of municipal bond (assuming both federal and state tax-exempt): 4.5%. Since 4.5% > 3.78%, the municipal bond fund offers a better after-tax return. So, the tax-equivalent yield is 6.62% (federal only), and the municipal bond fund offers a better after-tax return. This matches option A.