Required Rate of Return - Explained
What is a Required Rate of Return?
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Table of ContentsWhat is a Required Rate of Return DefinitionHow Does a Required Rate of Return Work?Here is the breakdown;What Does the Required Rate of Return Tell You?The Difference Between RRR and Cost of CapitalLimitations of RRR
What is a Required Rate of Return Definition
The required rate of return (RRR) refers to the least profit, return or money that an investor is expected to receive from an investment or holding the shares of a company. The minimum return that an investor gets as compensation for making an investment, holding a company's stock or investing in a project is described as RRR. RRR is an essential concept that is used in the evaluation of an investment, it tells whether an investment is profitable or otherwise. Also, the amount of risks that a project or an investment entails os projected through the RRR, the higher the RRR, the higher the risk. RRR is otherwise called the hurdle rate.
How Does a Required Rate of Return Work?
The Required Rate of Return (RRR) of an investment takes specific factors into account. These include the risk of the investment, the duration, inflation and liquidity factors. There are many methods of calculating RRR, they are;
- The dividend-discount model otherwise called the Gordon growth model.
- The Capital Asset Pricing Model (CAPM).
The dividend-discount model is often used by investors seeking to buy the stocks of companies that pay dividends. To calculate RRR using this model, the formula is highlighted below;
RRR = Expected dividend payment / Shareprice + Forecasted dividend growth rate
Here is the breakdown;
- Divide the expected dividend payment per share by the current price of stock.
- Add the value realizes to the forecasted dividend growth rate.
The formula for calculating RRR using CAPM is;
RRR = Risk - free rate of return + beta ( Market rate of return Risk-free rate of return)
Here is the breakdown; Beta = the risk coefficient of a security.
- Take the current risk-free rate of return and add to the beta.
- Subtract the market rate of return from the risk-free rate of return.
- Add the values to realize the RRR.
Afterwards; Deduct the risk-free rate of return from the market rate of return, then multiply by the beta of the security. Add the value of the result to the current risk-free RRR to determine the required rate of return.
What Does the Required Rate of Return Tell You?
In corporate finance and equity valuation, the required rate of return is an important metric used in evaluating a company or an investment. Since various companies and investors have diverging goals they seek to attain with investments, RRR is a little complicated. While some investors use the dividend-discount metric in calculating the RRR of a security, others use the CAPM formula. The inherent value of a security is affected by factors ranging from inflation, liquidity expectations, capital structure and preferences for risk-return. Investors who measure the RRR of an investment using the CAPM formula expect that a security with a high beta will have a higher RRR. The required rate of return tell investors whether to venture into a project, invest in a project of buy the stocks of a company. The inherent risks of an investment is determined through its RRR, given that a higher RR implies higher risks while an investment with low RRR indicate minimal risks. Here are some important things to know about the required rate of return;
- The required rate of return is the minimum profit or return an investor is expected to make from investment.
- Factors that influence RRR include risk of the investment, the duration, inflation and liquidity factors.
- Inflation as well as other factors that affect the rate of return must be factored in when calculating the RRR of an investment.
- Some investors seek investments with low RRR due to low risks that accompany them while others prefer investments with higher RRR which have higher rates.
The Difference Between RRR and Cost of Capital
Cost of capital refers to the returns that are expected on stocks or securities as issued by the company while the required rate of return refers to the minimum return investors expect on an investment to compensate them for the risk taken on such investments. Hence, RRR is not the same as cost of capital. Cost of capital is generally used by companies as the minimum return given by the company to cover the issuance of a security usually for the purpose of raising capital for a project. Predominantly, the required rate of return is higher than the cost of capital.
Limitations of RRR
Despite the seemingly importance of required rate of return, especially investors who seek to pump capital into companies or projects, it has some downsides. The major limitations of RRR are highlighted below;
- When calculating the required rate of return, inflation expectations are subjective. In most cases, its calculation does not give account to inflation expectations.
- Liquidity of investment is another vital factor that RRR does not give consideration to.
- Depending on the tolerance levels of various individuals and investors, RRR has varying results.
- Comparison between stocks in the same industry is impossible to achieve using the required rate of return.