Constant Yield Method

Finance a la shmoop... what is after-tax yield, well we'll presume you [Yield definition on 100 dollar bill]

know what standard yield is yeah okay so you have a stock trading for a

convenient exactly 20 bucks a share it pays a quarter a share four times a year

is a dividend or a dollar a year total in dividends its dividend yield is one

over twenty or five percent right you buy share for 20 bucks you get a dollar a

year back but you the investor pay tax on that buck a share of sweet hot

dividend love if you're a 35 percent bracketed taxpayer that is you pay 35 [35% taypay circled]

percent tax on the last dollar of your income well then you only keep 65 cents

on each dollar of dividend income that you receive and yes we note that there

is both federal and state and you know sometimes other taxes that go in here [List of taxes on sticky note]

like the Obamacare flavors or other county taxes but in total we're just

saying let's make up a story here that if you pay 35 percent tax on that buck

then your real after-tax yield is a lot less than the 5 percent the company

distributes to you, you calculate your after-tax yield by replacing that

"gross" dividend of a buck with a 65 cents of dividend that you keep [After-tax yield calculation]

after-tax in the numerator like that and then that 20 bucks you paid per share of

gently-used pacemakers dot-com stays in the denominator down there it looks like

this 65 cents divided by 20 bucks and that's 3.25 percent that

is 3.25 percent is your after-tax yield so that's as it applies [Man discussing after-tax yield to stock]

to stocks what about as it applies to bonds well in a way this calculation

matters a lot more because there's an entire industry in muni-bonds which pay

lower total rates of interest but which are generally insulated from paying [Person holding a muni-bond]

taxes so in a way muni bonds compete against fully taxable corporate bonds

for your bond investing dollar well tax rates for qualified dividends

meaning they're qualified for the various deductions from equity

investments are usually meaningfully lower than ordinary income rates so

let's look at the individual paying 35 percent marginal tax on long [Magnifying glass focuses on womans face]

term investment gains well they're likely paying something close to 50% tax

on ordinary income so we have a tale of two bonds foam depot corporation whose

bonds pay 7% and we're in the muni-city muni bonds which pay 4% which is better

the two bonds are of identical credit risk and if you're Joe hard-worker high [Hoe hammering a roof]

tax payer and supporter of government pork then which of these two bonds gives

you a better after-tax yield well if you pay 50 percent ordinary income tax then

you're 7% on that corporate is half or 3.5% after-tax that's the after-tax

yield got it and your muni bond carries no tax liability to you so the 4%

gross is the four percent net as well answer well go with the muni bond

and you two will be you know in the muni [Man discussing muni-bond after-tax yield and hat lands on his head]