$[$For this question, you will need to show your calculation with steps$]$

An investor is considering two bonds with equal maturities and equivalent

default risks:

Corporate Bond: Nominal yield $=7\%.$ Fully taxable at a $30\%$ tax rate.

Municipal Bond: Nominal yield $=5\mathrm{.}5\%.$ Tax$-$free at the federal level.

$($a$)$ Calculate the after$-$tax yield on the corporate bond and compare it with the tax$-$

exempt yield of the municipal bond. Based on these yields alone, which bond is

more attractive for an investor in the $30\%$ tax bracket, and when the same

investor goes into $15\%$ tax bracket. $[$Remember$,$ after$-$tax yield is not expected

return. The formula for after tax$-$yield is Nominal yield $(1-$Tax rate$)]$

$($b$)$ Assume the corporate bond carries additional liquidity risk, which requires an

investor to demand an additional $0\mathrm{.}6\%$ liquidity premium. Calculate the

adjusted yield for the corporate bond $($for both tax brackets$),$ factoring in the

liquidity premium. Does this make the corporate bond more attractive than the

municipal bond $($for each tax bracket$)?$

$($c$)$ Imagine investors are holding $$200$ million worth of municipal bonds and $$800$

million worth of T$-$bonds. Assume that both bonds are priced at $$100$ per bond.

Now suddenly, the federal government has decided to increase income tax. In

order to avoid more tax liabilities, investors reduce cumulative T$-$bond holding

by $$200$ million and transfer it to the other bond. What will be the impact on

bond prices $($and interest rates for both bonds$)?$ Verify your answer with a side$-$

by$-$side diagram that shows the markets for both bonds.