Definition
The Tax Equivalent Yield Formula is used to compare the yield between a tax-free investment and an investment that is taxable. It calculates the yield at which an investor should prefer a taxable investment over a tax-free one given their tax rate. The formula is Tax Equivalent Yield = Tax Free Yield / (1 – Investor’s Tax Rate).
Key Takeaways
- The Tax Equivalent Yield Formula is a calculation that converts the yield on a tax-free bond investment into a yield that is equivalent on a taxable investment. This method allows investors to compare taxable and non-taxable investments.
- It is particularly beneficial for investors in high tax brackets as it helps them assess the value of investing in a tax-free bond versus a taxable bond.
- The formula itself is fairly simple: Tax Equivalent Yield = Tax Free Yield / (1 – Your Tax Rate). This formula is an important tool for making informed investment decisions considering the tax implications.
Importance
The Tax Equivalent Yield (TEY) Formula is vital in the financial world because it provides investors with a clear understanding of the yield required on a taxable investment to equal the return on a tax-exempt investment like municipal bonds.
Effectively, this allows investors to make ‘apples to apples’ comparisons between taxable and non-taxable investments in terms of potential returns, taking into account their personal tax situations.
Since tax policies and individual circumstances can significantly affect the net returns on investments, the TEY Formula is a crucial tool for financial planning and decision-making.
Explanation
The Tax Equivalent Yield (TEY) formula is an invaluable tool in the financial world, particularly designed to aid investors and financial analysts make informed decisions. Essentially, its role is to assess and compare the yield or returns on taxable and tax-exempt investments.
It assists investors to pick the most beneficial investment option by evaluating the pre-tax yield a taxable investment would require to equal the return on a tax-exempt investment. The TEY formula is often employed by investors when considering municipal bonds, which are usually exempt from federal tax and, potentially, from state and local taxes too.
These tax savings can make municipal bonds more attractive than other higher-yielding, taxable investments. By using the TEY formula, an investor is able to convert the tax-exempt yield into a taxable equivalent, making it easier to compare directly with other taxable investment options.
Therefore, the main purpose of the tax equivalent yield formula is to level the playing field when comparing different types of investments, assisting investors in determining the most financially advantageous option.
Examples of Tax Equivalent Yield Formula
Municipal Bonds: An investor is considering investing in either a municipal bond, which does not levy federal taxes, or a corporate bond that does. The municipal bond offers a 4% yield, so the investor uses the Tax Equivalent Yield formula to determine the tax-adjusted return that they would need to obtain from a corporate bond to make it more lucrative. For example, if the investor’s tax bracket is 25%, they would need a yield from the corporate bond of approximately33% to reach the equivalent of the municipal bond after taxes.
Stocks vs. Bonds: An investor wants to evaluate the returns on a dividend-paying stock versus a taxable bond. The stock yields dividends of 5%, which are taxed at only 15%. When he used the Tax Equivalent Yield formula, he found that a taxable bond would need to yield about88% to outperform the tax-advantaged dividend.
Treasury Bonds versus Corporate Bonds: A conservative investor is looking to invest in a 10-year Treasury bond with a yield of 2%. However, he is also considering a corporate bond in a similar term length but is aware that the bond yield would be taxed at his ordinary income tax rate of 28%. Using the Tax Equivalent Yield formula, he discovers the corporate bond would need to yield approximately78% for it to be equivalent to the 10-year Treasury bond after tax.
FAQ: Tax Equivalent Yield Formula
What is the Tax Equivalent Yield Formula?
The Tax Equivalent Yield Formula is a calculation that determines the return on a tax-free investment that is equivalent to the return on a taxable investment. The formula is TEY = r / (1 – t), where ‘r’ represents the taxable bond yield, and ‘t’ represents the investor’s tax rate.
What does the Tax Equivalent Yield Formula help us understand?
This formula allows investors to compare the yield of tax-free investments such as municipal bonds, with taxable investments such as corporate bonds. By converting the yields to a tax-equivalent basis, investors can make direct comparisons and formulate better investment strategies.
How to use the Tax Equivalent Yield Formula?
To use the formula, simply input the yield of the taxable investment and the investor’s tax rate. Then, subtract the tax rate from 1, and finally, divide the yield of the taxable investment by this result. This gives you the tax equivalent yield.
Is the Tax Equivalent Yield Formula accessible to all kind of investors?
Yes, the formula is a simple equation that any investor can use to compare the potential returns of different investments, considering their own specific tax circumstances.
Related Entrepreneurship Terms
- Municipal Bond: This term refers to a loan made by a local government or their agencies. Interest earned on these bonds is often exempt from federal taxes and possibly state and local taxes as well.
- After-Tax Yield: It refers to the profit in percentage a person actually makes after all the taxes have been deducted from the interest earned on an investment.
- Interest Rate: This is the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percent of the loan outstanding.
- Tax Rate: This is the percentage at which an individual or entity is taxed. There are typically multiple levels of tax rates for different income brackets.
- Corporate Bond: A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as ongoing operations, M&A, or to expand business. The term refers to both short-term and long-term debt obligations.
Sources for More Information
- Investopedia: A comprehensive online resource providing definitions of finance terms, including the Tax Equivalent Yield Formula.
- Fidelity Investments: A broad finance and investment resource where you can find detailed explanations on various finance concepts.
- Corporate Finance Institute: A professional site providing a wealth of information in finance, including Tax Equivalent Yield Formula.
- The Balance: A robust personal finance resource, offering articles on a wide range of finance and business topics.