Question

Suppose you have two alternatives with equal risk: (a) You can invest $800 today and receive $1450 in 5 years, and (b) You can invest the $800 in a bank account that earns 11.42%. Which investment should you choose?

a. You will choose option (a) because it offers a rate of return of 12.63% which is higher than option (b) which offers a rate of 11.42%

b. You will choose option (b) because it offers a rate of return of 11.42% which is lower than option (a) which offers a rate of 12.63%

c. You will choose option (a) because it offers a rate of return of 10.09% which is lower than option (b) which offers a rate of 11.42%

d. You will choose option (a) because it offers a rate of return of 14.97% which is higher than option (b) which offers a rate of 11.42%

Answer 1

For a.We use the formula:  
A=P(1+r/100)^n
where   
A=future value
P=present value  
r=rate of interest
n=time period.

1450=800*(1+r/100)^5

(1450/800)^(1/5)=(1+r/100)

(1+r/100)=1.1263

r=1.1263-1

=12.63%(Approx)

Hence option a must be selected offering higher rate of return.Hence the correct option is:

a. You will choose option (a) because it offers a rate of return of 12.63% which is higher than option (b) which offers a rate of 11.42%