What is the Nominal Rate of Return?
The nominal rate of return is the amount of money generated by an investment before factoring in expenses such as taxes, investment fees, and inflation. If an investment generated a 10% return, the nominal rate would equal 10%. After factoring in inflation during the investment period, the actual (“real”) return would likely be lower.
However, the nominal rate of return has its merits since it allows investors to compare the performance of an investment irrespective of the different tax rates that might be applied for each investment.
How to Calculate the Nominal Rate of Return
Using the following formula, we can calculate the nominal rate of return:
Nominal rate of return = Current Investment Value/Original Investment Value – 1.
For example, suppose an investor puts $50,000 into a mutual fund. After a year passes, the account grows to a total of $55,000. The current investment value is $55,000, and the original investment value was $50,000.
55,000/50,000 – 1 = 0.1 (0.1 x 100)
Therefore, the nominal rate of return for this investment is 10% (0.1 x 100).
How is Nominal Rate of Return Used?
It is important for an investor to look beyond the nominal rate of return to understand the real profitability of an investment. If the nominal rate of an investment is 8% and the inflation rate is 4% then the real rate of interest is only 4%. Similarly, if a municipal bond and a corporate bond offer the same nominal rate of return that doesn’t necessarily means the return is the same for both.
Usually, the income from the municipal bond is tax exempted but the income from the corporate bond is taxable. So, with the equal nominal rate of return, the municipal bond earns more return than the corporate bonds.
The after-tax rates of return may significantly differ from the nominal rate. The amount of tax of an investment depends on the nature of the investment, time period of investment and the tax bracket the investor falls into. Thus, the after-tax rate of return may vary from one investor to another even if the investment amount, time and nominal rate of return are the same for both.
The real rate of return is calculated by deducting the inflation rate from the nominal rate of return. However, the real rate of return doesnt take into account the expenses caused by taxation.
The Issue with the Nominal Rate of Return
As mentioned earlier, the nominal rate of return is a simplistic rate of return used to compare investments. However, investors and decision-makers should be wary of using the nominal rate of return, as it does not accurately reflect the actual return that an investor will receive.
In making decisions, the nominal rate of return does not matter, investments should be evaluated and compared ultimately on the real rate of return and real risk premiums. Considering taxes, inflation, and other costs is important in determining the optimal investment.
For example, investment trusts are investment vehicles that typically receive favorable tax treatments. If comparing the investment trusts’ nominal returns with other investments, it may appear to generate worse returns. However, in reality, the investment trust will yield a greater real return to investors.
Why Does The Real Rate of Return Matter?
It is important to consider the real rate of return on an investment before looking to make an investment. In today’s time inflation rate is 5.7%, which means it is reducing the value of money as time passes by and taxes certainly take a chunk away too.
What’s left — the real rate of return — often can be unimpressive after considering these adjustments. Accordingly, investors must consider whether the risk associated with the investment is appropriate given the real rate of return.
Importance of Nominal Rate of Return
- The nominal interest is very important in the finance & economic world.
- It is necessary for computing various discounted values.
- The increase in nominal rate progressively defines the increasing rate of inflation in the economy.
- The whole economic base is related to the nominal rate of return. Therefore, many financial decisions are impacted as a result of a slight change in the nominal rate of return.
- Reduction in nominal rate results in higher output values & vice-e-versa.
Some of the advantages are given below:
It is used in discounting the cashflows standing at different intervals over the projected tenure of the project.
Further such rate of return is used to compute the net present values of cash flows. If the net cash flows are able to survive the effect of the nominal interest rate, the project is said to be viable.
Such interest rate is compared with the internal rate of return. The nominal rate of return is considered to cost of the project & such requirement is the minimum quantum of return. If the internal rate of return is lower than the nominal rate of return, the project is said to have reduced the wealth of shareholders & is, therefore, not viable to carry out.
Some of the disadvantages are given below:
It includes inflation & thus, the results are always inflation than the actual scenario.
Firms need to think upon the appropriate nominal rate. Any wrong basis in the rate may provide devastating results.
The nominal rate of return has now become the only basis of decision-making in finance, ignoring the other disciples of finance.
An important project may be rejected only due to negative NPV. Thus, other factors should be considered to confirm whether the project is actually not feasible.
The nominal rate of return is the backbone of the finance world today. Any computation in finance without an appropriate discount rate is considered vague & irrational.
Thus, the nominal rate of return has gained much importance in the changing world of the economic environment.