Consider the illustration in Section 7.3 where an investment choice was being made between taxable and tax-exempt bonds in the presence of tax-rate uncertainty and transaction costs.
a. Would you prefer to invest in 3-year taxable bonds or 3-year tax-exempt bonds yielding 10% and 7% pretax, respectively, if the annualized cost to switch from taxable to tax-exempt bonds, or vice versa, at the end of year 1 were 3% rather than 1%?
b. If instead of 3-year bonds that yield 10% per year (taxable) and 7% per year (tax-exempt), you could buy 1-year bonds at yields of 9.75% for taxables and 6.83% for tax-exempts, would you do so? Because they are 1-year bonds there are no switching costs.