Bond comparison and taxation
Peter Clemenza and Luca Brasi are arguing about the following bonds. Both bonds are for 5 years, each with the par value of $100,000. The coupon rates are compounded semi-annually. The coupon rate for bond #1 (favored by Mr. Clemenza) equals 1.8% and is tax free. The coupon rate for bond #2 (favored by Mr. Brasi) equals 2.6%, but it is subject to both federal and state taxes. The combination of federal and state taxes on this type of bonds usually average to about 30%. Peter Clemenza argues that since one does not have to pay taxes on bond #1, then it is a better investment. Luca Brasi says the bond #2 is a good investment, because it will earn higher return than the bond #1. Can you settle their argument? Which bond would you recommend?
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