Question

Douglas​ Keel, a financial analyst for Orange​ Industries, wishes to estimate the rate of return for two​ similar-risk investments, X and Y. ​ Douglas's research indicates that the immediate past returns will serve as reasonable estimates of future returns. A year​ earlier, investment X had a market value of $27,000​; and investment Y had a market value of \$64,000. During the​ year, investment X generated cash flow of $2,025 and investment Y generated cash flow of $ 7,327. The current market values of investments X and Y are $27,781 and $64,000​, respectively.

a. Calculate the expected rate of return on investments X and Y using the most recent​ year's data.

b. Assuming that the two investments are equally​ risky, which one should Douglas​ recommend? ​ Why?

Answer 1

Answer to Part a.

Expected Rate of Return=(Current Market Value-Prior Market Value + Cash Flow)/Prior Market Value* 100

Expected Rate of Return on Investment X:
Expected Rate of Return = ($27,781 - $27,000 + $2,025) / $27,000 * 100
Expected Rate of Return = $2,806 / $27,000 * 100
Expected Rate of Return = 10.39%

Expected Rate of Return on Investment Y:
Expected Rate of Return = ($64,000 - $64,000 + $7,327) / $64,000 * 100
Expected Rate of Return = $7,327 / $64,000 * 100
Expected Rate of Return = 11.45%

Answer to Part b.

Investment Y should be recommended as it has Expected Rate of Return as compared to Investment X.