Problem:

The Joneses plan to build a new home in about 4 years and wish to consider the purchase of a city lot now to avoid the inflation of land prices. A lot in an area that they consider desirable at this time can be purchased for $25,000. The only cash flows during the period will be annual property taxes of about $300 (after income tax deductions). No income will be obtained while it is owned. The realtor assures them that in 4 years the lot will cost $38,000. The Joneses have $25,000 currently invested in tax-exempt municipal bonds that pay 8.5% per year. They believe that they can sell the bonds for at least $25,000 at any time. If they decide to sell the lot in 4 years rather than build on it, they have to pay a capital gains tax of about $2,680 plus a real estate commission of $2,280.

Requirements:

Determine the prospective rate of return on the investment in the lot if the Joneses build a home on it and if they sell the lot 4 years hence. Analyze the proposal for the family, including consideration of irreducible. Please justify your answer with the appropriate calculations and formulas.