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 $20,000; investment Y had a market value of $55,000. During the year, investment X generated cash flow of $1,500 and investment Y generated cash flow of $6,800. The current market values of investments X and Y are $21,000 and $55,000, 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

Calculate the expected rate ofreturn on investment-X using the following formula C+(R-P) Rate of return- Here, C is the cash-flows generated during the year Pi is the current year of the investment. Po is the previous year market value of the investment C+(R-P) S1,500+(S21,000-S20,000) $1,500+S1,000 Rate of return =- $20,000 $20,000 $2,500 $20,000 0.125 or 12.5% Therefore, the expected rate of retum on investment-X is 12.5%

Calculate the expected rate ofreturm on investment-Y C+(R-P) Rate of return = S6,800+(S55,000-S55,000) $55,000 $6,800 0 S55,000 0.1236 or 12.36% Therefore, the expected rate ofretum on investment-Y is 12.36% the amount ofrisk on both the investments are equal Therefore, investment-X is recommended