Given a choice of two investments, would you choose one that pays a total return

Question

Given a choice of two investments, would you choose one that pays a total return of 10 percent over 5 years or one that pays 0.2 percent per month for 5 years? What annual rate of return does each give you? Instruction: Enter your answers in percentages to the nearest hundredth, for example, 3.00 for 3 percent. The return of 10 percent over 5 years provides an annual return of The return of 0.2 percent per month for 5 years provides an annual return of The investment that pays (Click to select) percent. percent. is preferable.

Explanation / Answer

Option 1 :

10% Return in 5 years

Lets assume you have $1000 to invest for 5 years.

At the end of the 5th year, you will get $100 as interest (i.e. 10% of $1000)

Option 2 :

Given that, 0.2% per month ie 0.2% x 12 = 2.4% per annum

Lets assume you have $1000 to invest for 5 years.

Case 1 : If you earn Simple Interest, then you earn

Simper Interest = Principal x Number of Years x rate of Interest

i.e. SI = $1000 x 5 x 2.4% = $120

Case 2 : If you earn compound Interest, then you earn

Compound Interest = Principal x (1 + Interest rate )^ Number of year - Principal

CI = $1000 x (1.024)^5 - 1000 = $125.89

(I) The return of 10% over 5 year period provides an annual return of 2% per annum [10%/5]

(II) The return of 0.2% per month over 5 year period provides an annual return of 2.4% per annum [0.2% x 12]

(III) The investment that pays 0.2% per month compounded annually is preferable

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