If an investment costing $2000 is expected to generate real cash flows of $900 p.a.for three years and prices are expected to increase at a rate of 10% p.a. ,what is the real required rate of return if the nominal cost of capital is 15%?
A)6%
B)5%
C)1.05%
D)4.55%

Question

Quizplus · Accepted Answer

To calculate the real required rate of return, we first need to adjust the nominal cost of capital for inflation. Using the Fisher equation:

Real Required Rate of Return = (1 + Nominal Required Rate of Return) / (1 + Inflation Rate) - 1

In this case, the nominal required rate of return is 15% and the inflation rate is 10%, so:

Real Required Rate of Return = (1 + 0.15) / (1 + 0.10) - 1
Real Required Rate of Return = 1.1667 / 1.1 - 1
Real Required Rate of Return = 0.0591, or 5.91%

Since the expected real cash flows of $900 p.a. are less than the initial investment cost of $2000, the real required rate of return must be less than the nominal cost of capital of 15%. The closest answer choice to our calculation is D, 4.55%.

If an Investment Costing $2000 Is Expected to Generate Real