Question

If a client in the 30% marginal income tax bracket can earn an after-tax rate of return of 7% when the estimated inflation rate during the holding period of an investment is 4%, the client's real rate of return is

A)7%.
B)less than 7%.
C)10%.
D)more than 7%.

Answer 1

The client's real rate of return is less than 7% because after adjusting the after-tax nominal return of 7% for an inflation rate of 4%, the real rate of return is approximately 2.885%.

Step-by-step explanation:

If a client in the 30% marginal income tax bracket can earn an after-tax rate of return of 7% when the estimated inflation rate during the holding period of an investment is 4%, the client's real rate of return is less than 7%. An after-tax rate of return already factors in the effect of taxes on the nominal rate. To find the real rate of return, you have to adjust the after-tax return for inflation. Using the formula:

Real Rate of Return = [(1 + After-Tax Nominal Rate) / (1 + Inflation Rate)] - 1

Inserting the given values:

Real Rate of Return = [(1 + 0.07) / (1 + 0.04)] - 1

Real Rate of Return = (1.07 / 1.04) - 1

Real Rate of Return = 1.02885 - 1

Real Rate of Return = 0.02885 or 2.885%

Thus, the real rate of return, after adjusting for inflation, is significantly less than the nominal after-tax rate of return of 7%. Therefore, the correct answer is B) less than 7%.