Question

WG Investors is looking at three different investment opportunities. Investment one is a​ five-year investment with a cost of

​$260 and a promised payout of $520 at maturity. Investment two is a​ seven-year investment with a cost of ​$260 and a promised payout of

​$702. Investment three is a​ ten-year investment with a cost of ​$260 and a promised payout of ​$1,196.

WG Investors can take on only one of the three investments. Assuming that all three investment opportunities have the same level of​ risk, calculate the effective annual return for each​ investment, and select the best investment choice.

What is the effective annual return for investment​ one, a​ five-year investment with a cost of ​$260 and a promised payout of $520 at​ maturity?

Answer 1

When the investments have the same level of risk then effective annual return can be calculated by the following formula:

Effective annual return = Maturity value of the investment - Cost of the investment / Cost of the investment * 100 / Time period of investment

Calculation of Effective annual return of investment 1:

Maturity value = $520

Cost = $260

Time period = 5 year

Putting these values in the above formula, we get,

Effective annual return = ($520 - $260) / $260 * 100 / 5

Effective annual return = $260 / $260 * 100 / 5 = 20%

Calculation of Effective annual return of investment 2:

Maturity value = $702

Cost = $260

Time period = 7 year

Putting these values in the above formula, we get,

Effective annual return = ($702 - $260) / $260 * 100 / 7

Effective annual return = $442 / $260 * 100 / 7 = 24.29%

Calculation of Effective annual return of investment 3:

Maturity value = $1196

Cost = $260

Time period = 10 year

Putting these values in the above formula, we get,

Effective annual return = ($1196 - $260) / $260 * 100 / 10

Effective annual return = $936 / $260 * 100 / 10 = 36%

Since investment 3 is giving the highest effective annual return of 36%, so it should be selected.