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Suppose 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. You expect the general inflation to be 3% during the investment period. You can buy a high-grade municipal bond costing $10,000 and that pays interest of 9% ($900) per year. This interest is not taxable. A comparable high-grade corporate bond is also available that is just as safe as the municipal bond, but that pays an interest rate of 12% ($1,200) per year. This interest 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 MARR, can you make a choice between these two bonds?
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