A financial analyst for Smart Securities Limited, Paul Chan, wishes to estimate the rate of return for two similar-risk investments, A and B. Paul’s research indicates that the immediate past returns will serve as reasonable estimates of future returns. A year ago, investment A and investment B had market values of $63,000 and $35,000, respectively. During the year, investment A generated cash flows of $6,100, and investment B generated cash flows of $2,800. The current market values of investments A and B are $71,000 and $32,000, respectively.
a. Calculate the expected rate of return on investments A and B using the most recent year’s data.
b. Assuming that the two investments are equally risky, which one should Paul recommend? Why?