Find the real rate of return for the investment you purchased for $100 five years ago, that has a current price of $110, and dividends of $2 per share. The inflation rate is 2%.
Answer (1)
To calculate the real rate of return for your investment, we'll follow these steps:
Calculate the nominal rate of return.
The nominal rate of return is the percentage increase in the value of the investment, including dividends and capital gains, before adjusting for inflation.
Initial investment (5 years ago): $100
Current price: $110
Dividends per share over 5 years: $2
First, calculate the total return, which includes both the increase in the price of the investment and the dividends received:
Total Return = ( Current Price − Initial Investment ) + Dividends
Total Return = ( 110 − 100 ) + 2 = 12
Now, express this as a percentage of the initial investment:
Nominal Rate of Return = ( 100 12 ) × 100%
Nominal Rate of Return = 12%
Adjust for inflation to find the real rate of return.
The real rate of return takes into account the inflation rate to show the actual increase in purchasing power.
The formula to find the real rate of return is:
Real Rate of Return = 1 + Inflation Rate 1 + Nominal Rate − 1
Substitute the values for the nominal rate and inflation rate (converted to decimal):
Real Rate of Return = 1 + 0.02 1 + 0.12 − 1
Real Rate of Return = 1.02 1.12 − 1
Real Rate of Return = 1.098 − 1
Real Rate of Return = 0.098 or 9.8%
Therefore, the real rate of return on your investment is approximately 9.8% .
