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Tax Equivalent Yield - Definition, Formula, How to Calculate Tax Equivalent Yield? - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
of WallStreetmojo watch the video
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till the end and also if you are new to
this channel and you can subscribe us by
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clicking the bell icon Friends today we have going to learn a concept that is known as the tax
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equivalent yield formula now when we
talk about the tax equivalent yield
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formula we have a formula that's right
in front of us the tax free yield that
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the percentage upon 1 minus the tax rate
minus 1 okay you mustn't be getting it
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what exactly things are going on so
let's understand this formula first now
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the first question that may arise that
why should you use this formula that's
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the first question and the answer to
this formula will help you to compare
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the yield between tax-free all right for
you a tax-free investment and the tax
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investment right so here's the tax
equivalent formula the tax equivalent
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formula is something like this which is
equal to your tax-free yield divided by
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1 minus your tax rate right the example
of the tax rate formula let's let's
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discuss this and understand how exactly
we will go about let's say there's this
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this lady called Miss Olivia and she is
new in the investment world she wants to
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find out whether she should go for taxed
investment or non-taxed investments
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worth basically known as your tax-free
investments so she founds she finds out
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that the taxed investments pay out the
yield in the neighborhood of 12%
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on an average and on the other hand
there are other investments which is
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known as your tax-free investment which
pays only 8% on an average and the tax
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rate is standing at let's say 35%
so you need to guide Miss Olivia by
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choosing which investments would be or
which investors would be more beneficial
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for her so by using this formula we can
absolutely find the tax equivalent yield
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for this company so your tax equivalent
yield is going to be your tax yield
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divided by
1 minus your tax rate right so your
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tax yield is going to be your tax-free
interest rate right or your tax yield so
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you have written the wrong formula it's
it's the tax-free yield not the tax
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yield tax-free yield divided by 1
minus tax rate so we here will we'll put
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8% over here and will deduct
1 minus the tax rate which is 0.35
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okay yeah we'll close the bracket so
0.65 all right so let's just divide
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instead of 8% will just write
0.08 divided by 0.65 so will will have
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the answer as 0.08 divided by 0.65 we
have 12.3% right so from the about tax
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equivalent yield calculation we are
clear that miss olivia is certainly it
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needs to invest in the tax-free
investments and not the tax investments
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now let's understand the explanation
part of the tax equivalent yield formula
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now as you can see in the formula it
compares the the the comparison between
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the tax-free yield and the tax and
there are two components so let's
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discuss about discuss about the first
component which is the tax-free yield
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now to find out the tax field all you
need to do is to look around at the
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yield of the municipal bonds right so
this bonds are generally issued by the
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Treasury or the government and and you
don't need to pay any tax for the return
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that you earn on your investments right
now there's another thing called the
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second component which we have in our
formula as the 1 minus the tax rate so
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1 minus tax rate basically helps you
to find out the yield it is being taxed
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yielding it has been taxed now this read
this is
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reason we use this in the denominator
and to find out how beneficial it is to
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invest in the tax instruments so by
using this formula you would understand
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actually how much yield you would earn
if you need to pay taxes I mean if you
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need to pay taxes on your tax
reinvestment and that will keep up the
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yield at the similar level of both of
the investment and the tax level so
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you'd be able to find out whether the
tax investment where the D tax
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investment is basically good or not so
that's what we are supposed to find now
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what exactly is the use of the tax heal
equivalent formula
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so basically investor should use this
formula to find out whether it is
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prudent you can say to be higher taxes
and for investing in the tax investments
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so let's understand this by using a
simple example let's say there's a guy
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called mr. Ramesh has decided to look at
both the taxed investments and the
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tax-free investments the idea is to
reduce the tax payment as much as he can
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he finds out the tax investment offered
a rate or the yield of 9% and a
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tax free investment offered him a yield
of 6% and let's say the tax rate
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the tax rate is 40% so to find out
he uses the tax eel so by using the
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formula he gets the tax yield something
like this the tax yield is going to be
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is equal to your tax free 6%
okay divided by the 1 minus the tax rate
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so what is your 1 minus tax 40%
so that's sixty percent so if
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you divide 6/60 you get
exactly 10% so mr. Ramesh finds
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out that the tax investment isn't a good
deal and and he should go for basically
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the tax free investment now let's
understand this with the help of a
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calculator
put some numbers now let's say your
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tax-free yield is 10% and your tax rate
is 40% so all the numbers are over here
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you can see 16.67% is the tax
equivalent yield formula so what a
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comparison that we are making the
tax-free yield and over here we are
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asking the tax rate so what will happen
to the ratio if your tax yield let's say
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goes to 11% and keeping the tax
rate as the same it increases so if your
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tax-free yield increases keeping the tax
rate are same the ratio increases and
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just see over here instead of 11 if we
just take 9 the tax hill increases so as
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the tax-free yield decreases keeping the
tax rate is same your ratio basically
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decreases I'm sorry yeah so the ratio
basically decreases that's 15% so this
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is the relation between the tax-free
yield and the ratio and the tax rate so
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you can put down your own numbers keep changing some numbers and try punching
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it and come out with some really good
conclusions so that's it for this
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particular topic if you have learned and
enjoyed watching this video please like
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thank you everyone
Cheers
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