Why are rates of return superior to dollar returns when comparing different potential investments? (Hint: Think about size and timing.)

Why are rates of return superior to dollar returns when comparing different potential investments? (Hint: Think about size and timing.)

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June 3, 2021
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Why are rates of return superior to dollar returns when comparing different potential investments? (Hint: Think about size and timing.)

Answer and ExplanationSolution by a verified expert

Explanation

Rates of return approach expresses the return earned on a particular investment as a percentage of the initial investment. This method is better than the dollar return method as it takes into account the time value of money and reflects how much has investment altered in proportion to the initial investment. For instance a rate of return of 10%, conveys that the return on the investment is 10% and therefore investment has grown by 10% of its initial investment. This method shows how the value of investment has changed over time. Rates of return are expressed on the basis of per unit of investment.
 
Moreover rates of return can also be used in cases where multiple cash flows exist to express the return of investment by applying the annualized rate of return; which would not be possible to estimate using the dollar return approach.

Verified Answer

Rates of return is a better method to calculate returns than dollar returns as it takes into consideration the time value of money and can also be used to calculate returns where multiple cash flows exst.

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