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Inflation and Real Rate of Return

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1. A man bought a 5% tax-free municipal bond. It cost $1000 and will pay $50 interest each year for 20 years. At maturity the bond returns the original $1000. There is 2% annual inflation. what real rate of interest will the investor receive?
1. What rate of return will the investor receive after the effect of inflation has been accounted for?
2. What will be the value in current dollars of the $1000 the man will receive in 20 years?

2. A man wishes to set aside some money for his daughter's college education. His goal is to have a bank savings account containing an amount equivalent to $20,000 in today's dollars at the girl's 18th birthday. The estimated inflation rate is 8%. The bank pays 5% compounding annually..
1. How much in then current dollars will be required to have an amount equivalent to $20,000 today?
2. Assume that after the man calculates that he will have to deposit more than $29,000 to have $20,000 buying power in 14 years, he finds another bank that will pay him 6%. How much will he have to deposit in the new bank?

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Solution Summary

There are two problems. Solution to first problem depicts the methodology to calculate the inflation adjusted rate of return and future value in current dollars. Solution to second problem describes the steps to estimate the future value in current dollars.

Solution Preview

1:
1. 2.9%. Please refer to attached excel file for calculations.
2. Value of $1000 in current dollars=FV/(1+inflation rate)^no. of ...

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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