Required rate of return
The required rate of return (RRR) is the minimum return that an investor expects to receive for investing in a particular asset or project. It represents the minimum level of return that an investor will accept for taking on the risk of an investment. The RRR is used to evaluate investment opportunities and determine whether they are financially viable. It is typically expressed as a percentage and is used to compare the potential return of different investments. It is also known as the hurdle rate or discount rate.
Required rate of return formula
The required rate of return (RRR) formula is used to calculate the minimum return that an investor expects to receive for investing in a particular asset or project.
The most commonly used formula for calculating the RRR is the Capital Asset Pricing Model (CAPM) which is:
RRR = Risk-free rate + (Beta x (Market return - Risk-free rate))
Where:
- Risk-free rate: the return on a risk-free investment, such as a US Treasury bond
- Beta: the volatility or systematic risk of the asset or project relative to the overall market
- Market return: the return on a broad market index, such as the S&P 500
Another formula for calculating RRR is the Weighted Average Cost of Capital (WACC) which is:
RRR = (E/V x Ce) + (D/V x Cd (1-T))
Where:
- E: the market value of equity
- V: the total market value of the company (equity + debt)
- Ce: the cost of equity
- D: the market value of debt
- Cd: the after-tax cost of debt
- T: the corporate tax rate
It's important to note that different industries, companies, and investments may use different formulas or methods to calculate their required rate of return. It's also important to keep in mind that the RRR is not a fixed value and can change over time, depending on factors such as changes in interest rates and risk perception.
Required vs. Expected rate of return
The required rate of return (RRR) and the expected rate of return (ERR) are related but distinct concepts.
The RRR is the minimum return that an investor expects to receive for investing in a particular asset or project. It represents the minimum level of return that an investor will accept for taking on the risk of an investment. The RRR is used to evaluate investment opportunities and determine whether they are financially viable.
The ERR, on the other hand, is the return that an investor expects to receive on an investment, given the level of risk associated with it. It is an estimate of the average return that an investor can expect to receive over time. The ERR is used to make investment decisions and to compare the potential returns of different investments.
In general, the RRR is higher than the ERR because investors require a higher return to compensate for the risk they are taking on. Investors will only invest in an opportunity if the expected rate of return is greater than or equal to the required rate of return.
References
- Liljeblom, E., & Vaihekoski, M. (2004). Investment evaluation methods and required rate of return in Finnish publicly listed companies. Finnish Journal of Business Economics, 53(1).
- Gordon, M. J., & Shapiro, E. (1956). Capital equipment analysis: the required rate of profit. Management science, 3(1), 102-110.
- Ahn, C. M., & Thompson, H. E. (1989). An analysis of some aspects of regulatory risk and the required rate of return for public utilities. Journal of Regulatory Economics, 1(3), 241-257.
