A company normally will generate maximum after-tax return on investments by investing in tax exempt instruments.

Question

Options

• ATrue
• BFalse

• A
  77% (30)
• B
  23% (9)

Explanation

Option A is correct because tax-exempt instruments (such as municipal bonds) allow a company to retain 100% of investment income - no portion is surrendered to taxes. For companies in high marginal tax brackets, the after-tax yield on tax-exempt instruments frequently exceeds that of comparable taxable instruments, even when the taxable instruments carry higher nominal (pre-tax) rates.

Option B (False) is incorrect because it ignores the tax drag on taxable investment returns. A company investing in taxable instruments must share a portion of each dollar earned with the government, reducing the effective yield - so the after-tax return is inherently lower than the stated rate.

Memory tip: Think of tax-exempt as "what you see is what you keep." With taxable instruments, you always leave money on the table for the IRS, so after-tax returns are always diluted. The higher a company's tax rate, the more valuable tax exemption becomes.

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