You have $10,000 cash that you want to invest. Normally, you would deposit the money in a savings account that pays an annual interest rate of 6%. However, you are now considering the possibility of investing in a bond. Your alternatives are either a nontaxable municipal bond paying 9% or a taxable corporate bond paying 12%. Your marginal tax rate is 30% for both ordinary income and capital gains. (The marginal tax rate of 30% means that you will keep only 70% of your bond interest income.) You expect the general inflation rate to be 3% during the investment period. You can buy a high‐grade municipal bond costing $10,000 that pays interest of 9% ($900) per year. This interest is not taxable. A comparable high‐grade corporate bond for the same price is also available. This bond is just as safe as the municipal bond but pays an interest rate of 12% ($1,200) per year. The interest for this bond is taxable as ordinary income. Both bonds mature at the end of year 5.
(a) Determine the real (inflation‐free) rate of return for each bond.
(b) Without knowing your earning‐interest rate, what choice would you make between these two bonds?