Jake can invest in a fully taxable bond yielding 10% or in a municipal bond yielding 7%. His marginal tax rate is 35%. In which bond should Jake invest, and what would his real, after-tax
Return on this investment be if inflation is 4%?

Question

Quizplus · Accepted Answer

CTo determine the better investment, we calculate the after-tax return for both options and adjust for inflation. For the fully taxable bond at 10%, the after-tax return is 10% * (1 - 0.35) = 6.5%. Adjusting for inflation, the real return is 6.5% - 4% = 2.5%. For the municipal bond, which is tax-exempt, the after-tax return is the same as the nominal return, 7%. Adjusting for inflation, the real return is 7% - 4% = 3%. Therefore, the municipal bond offers a better real, after-tax return. However, the provided options do not exactly match these calculations, but based on the given choices, option A is the closest correct choice, suggesting the municipal bond is the better investment. Option C incorrectly suggests investing in the fully taxable bond with a real after-tax return of 2.40%, which is not the optimal choice based on the calculations.

Jake Can Invest in a Fully Taxable Bond Yielding 10