GMAT Focus EditionData InsightsMedium
A financial analyst is evaluating the potential returns of two investment strategies, Strategy P and Strategy Q, over a 5-year period. Strategy P involves an initial investment of $10,000 and is projected to yield an average annual return of 8%. Strategy Q involves an initial investment of $12,000 and is projected to yield an average annual return of 6%. Both strategies compound annually. Which strategy is projected to yield a higher total return at the end of the 5-year period, and by approximately how much?
- AStrategy P, by approximately $347
- BStrategy Q, by approximately $347
- CStrategy Q, by approximately $1,260
- DStrategy P, by approximately $1,260
Show answer & explanationAnswer & explanation
Correct answer: A. Strategy P, by approximately $347
To determine the higher total return, calculate the future value for each strategy using the compound interest formula and then find the difference.
Why the other options are wrong
- B. Strategy P yields approximately $14,693.28, and Strategy Q yields approximately $16,057.78. Strategy P's return is $4,693.28 and Strategy Q's return is $4,057.78. The question asks for the total return, not the future value. Strategy P's total return is higher by approximately $635.50. This option is incorrect.
- C. Strategy P yields approximately $14,693.28, and Strategy Q yields approximately $16,057.78. Strategy P's return is $4,693.28 and Strategy Q's return is $4,057.78. The difference is $635.50. This option is incorrect.
- D. Strategy P yields approximately $14,693.28, and Strategy Q yields approximately $16,057.78. Strategy P's return is $4,693.28 and Strategy Q's return is $4,057.78. The difference is $635.50. This option is incorrect.
Compound Interest Calculation
Compound interest is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.
- Interest is reinvested and earns interest itself.
- Formula: A = P(1 + r/n)^(nt), where A = future value, P = principal, r = annual interest rate, n = number of times interest is compounded per year, t = number of years.
- Crucial for long-term investment growth.
Memory trick: Calculating compound returns needs careful attention to principal and interest.