Several yars ago, a Texas bank offered a thirty-year CD with an annual return in

Question

Several yars ago, a Texas bank offered a thirty-year CD with an annual return indexed to inflation. The rate offered was the annual percentage increase in the CPI plus 4 percent. Suppose that you are in the 28 percent marginal tax bracket and require a 5 percent real return after taxes. Suppose also that the annual inflation rate last year was 3 percent, so this year's annual rate on the CD investment is set at 7 percent.

a.Show the after-tax real return you would earn, assuming that the inflation rate stays at 3 percent and the CD rate offered is 7 percent.

b. what ex ante nominal rate should you require stead to keeD your after-tax real yield at 5 percent?

Explanation / Answer

Answer

1. For calculating Real rate of Interest     = (N*(1-t)-I)/(1+I)

where, N = Nominal rate of Return, T = tax , I = Inflation

now putting these values

Real Rate of Return = {7% * ( 1- 28%) - 3%} / (1 + 3%)

Real Rate of Return = 1.98%

2. now if you need to 5% as real rate of return then

again use this formula & put the Values in formula & now we need to calculate nominal rate of interest (N)

Real rate of Interest     = {N*(1-t)-I}/(1+I)

5% = { N * (1-28%) - 3%} / (1 + 3% )

N = {5% * (1+3%) + 3%} / (1-28%)

N = 11.32%

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