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What is Real rate of return & Nominal rate of return?

Real rate of return:

A real rate of return is a rate of return which give returns value after adjusting all the related information or factors which helps to calculate return on investment. The other factors are tax, inflation rate etc. It provides correct value of return on investment. This rate helps to decide whether it is beneficial to invest in that project for investor or not.

Formula:

Real rate of return = [(1+nominal rate) / (1+inflation rate)] -1

Nominal rate of return:

A nominal rate of return is a rate which doesn’t adjust any further information or you can say it does not include other factors which affects the return on investment. It does not help to make a correct investment decision.  The rate tells how much investor approximately earns annually on investing in a project.

Formula:

Nominal rate of return = Market value – Original investment value / Original investment value

Example:  Mr. Chopra has invested Rs. 5000 on a project. The nominal rate of return is 7% and the inflation rate is 2%. Find out the real rate of return and nominal rate of return. 

Solution: Nominal rate of return s 7% (given in question)

Real rate of return = Nominal rate of return –inflation rate

= 7-2 = 5% approximately

Real rate of return = [(1+nominal rate) / (1+inflation rate)] -1

= [(1+0.07) / (1+0.02)] -1

= [(1.07) / (1.02)] -1

= 1.049 – 1

= 4.9 %

Mr. Chopra gets 4.9% or 5% as a rate of return for investing in a project and the value of the return is Rs. 245.

Example: There are two projects, project A and project B. Both the project provide fixed rate of return that is 12% and 8%. The inflation rate is 3%. The tax rate is 20%. Find out the nominal rate of return after tax and real rate of return after tax of both the projects. And also find out in which projects Mr. Mohit should invest to get more return in comparison to other projects.

Solution: Nominal rate of return:

Project A:

Nominal rate *(1-tax)

= 12*(1-0.20)

= 12*0.8

= 9.6%

Project B:

Nominal rate *(1-tax)

= 8*(1-0.20)

= 8*0.8

= 6.4%

Real rate of return:

Project A:

Nominal rate *(1-tax)

= 12*(1-0.20)

= 12*0.8

= 9.6%

Inflation rate = 3%

Real rate of return = [(1+nominal rate after tax) / (1+inflation rate)] -1

= [(1+0.096) / (1+0.03)] -1

= 1.064 -1

= 6.4%

Project B:

Project B:

Nominal rate *(1-tax)

= 8*(1-0.20)

= 8*0.8

= 6.4%

 

Real rate of return = [(1+nominal rate after tax) / (1+inflation rate)] -1

= [(1+064/ (1+0.03)]-1

= [1.064/1.03]-1

= 1.033 -1

= 3.3%

Mr. Mohit should invest on project A because the real rate is 6.4% in comparison to project B which provides 3.3% return. To take a decision whether to choose the best alternatives always consider real rate of return.

Example: Mr. Singh invests Rs. 2, 00,000 in a bond.  The market value of the investment is Rs. 2, 60,000. Find out the nominal rate of return.

Solution:

 Nominal rate of return = Market value – Original investment value / Original investment value

= 2, 60,000-2, 00,000/2, 00,000

= 60,000/2, 00,000

=0.3

= 30%

 

 

 

 

 

 

 

 

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