Question

loretta buys a one-year debt security on 12/31/2002 for $10,000 which will pay her a nominal interest rate of 5% from 12/31/2002 to december 12/31/ 2003m the inflation rate is 2% , loretta has a tax rate of 40%

1- how much nominal interst does she earn in one year ?

2- how much does loretta pay in taxes on her interest income?

3- how much is after- tax nominal income for loretta ?

4- how much principle does loretta loose because of inflation ?

5- how much real income interst does loretta earn ?

6- how much lorerra after tax real income ?

7- the nominal interest income loretta earned is distrubuted to the following : loretta 20% , the gocerment gets 40% for taxes, inflaction gets 40% (true or false) ??

Answer 1

Part A

Nominal interest earned = value of security x rate of interest

                                             = $10,000 x 5%

                                             = $500

Part B

Tax amount = Nominal interest earned x tax rate

                       = $500 x 40%

                       = $200

Part C

After tax nominal income = Nominal interest earned – tax amount

                                                 = $500 - $200

                                               = $300

Part D

Principle lost due to inflation = value of investment x interest rate

                                                            = 10,000 x 2%

                                                            = $200