According to the Rule of 72, you can do which one of the following?

• A. Determine the effective annual rate by multiplying the nominal rate by 72.
• B. Estimate the number of years required to double an investment by dividing 72 by the annual interest rate.
• C. Find the future value of an investment by raising 72 to the power of the number of years.
• D. Calculate the present value of a future cash flow using a 72% discount rate.

Answer: (B)

Verified step by step guidance

1. Understand the Rule of 72: The Rule of 72 is a simple formula used to estimate the number of years required to double an investment at a fixed annual interest rate. It is a shortcut for understanding the effects of compound interest.
2. Identify the formula: The formula is \( \text{Years to double} = \frac{72}{\text{Annual Interest Rate}} \). This means you divide 72 by the annual interest rate (expressed as a percentage) to estimate the doubling time.
3. Clarify the options: The correct application of the Rule of 72 is to estimate the number of years required to double an investment, not to calculate effective annual rates, future values, or present values.
4. Apply the formula conceptually: For example, if the annual interest rate is 6%, you would divide 72 by 6 to estimate the doubling time. This gives \( \text{Years to double} = \frac{72}{6} \).
5. Reinforce the concept: The Rule of 72 is an approximation and works best for interest rates between 6% and 10%. It is not a precise calculation but a useful tool for quick estimations in financial planning.