You have $10,000 cash which you want to invest. 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 rate of inflation to be 6% during the investment period. You can buy a high grade municipal bond costing $10,000 which pays interest of 9% 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 paying interest rate of 12% per year. This interest is taxable as ordinary income. Both bonds mature at the end of year 5.

The missing part of the question is shown in bold format.

You have $10,000 cash which you want to invest. 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 rate of inflation to be 6% during the investment period. You can buy a high grade municipal bond costing $10,000 which pays interest of 9% 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 paying interest rate of 12% per year. This interest is taxable as ordinary income. Both bonds mature at the end of year 5.

Determine the real (inflation - free ) rate of return of each bond

the  inflation free rate of return of the nontaxable municipal bond is 2.8%

the inflation free rate of return of the taxable corporate  bond is 5.0%

Explanation:

Given that :

A nontaxable municipal bond pays an interest of  9% annually

A  taxable corporate bond pays an interest of  12% annually

The marginal  tax rate =  30%    for both ordinary income and capital gains

The rate of inflation    f  =   6%

Determine the real (inflation - free ) rate of return of each bond

The inflation free rate of return can be determined by using the formula:

where;

r = inflation free rate of return

so;

For the inflation free rate of return of the nontaxable municipal bond ; we have;

Thus; the  inflation free rate of return of the nontaxable municipal bond is 2.8%

The  inflation free rate of return of the taxable corporate  bond is as follows:

Thus; the inflation free rate of return of the taxable corporate  bond is 5.0%

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explanation:

b. check your rearview mirror

explanation: