Definition and Examples of Required Rate of Return

What Is Required Rate of Return (RRR)?

The required rate of return (RRR) is the minimum return an investor demands for holding a company’s stock, as compensation for the associated risk. It is a crucial metric in determining the profitability of potential investment projects in corporate finance. The RRR is also referred to as the hurdle rate, denoting the level of compensation needed for the risk involved.

Riskier projects typically have higher hurdle rates or RRRs than less risky ones, reflecting the principle that greater risk warrants higher compensation.

Key Takeaways

• The RRR represents the minimum return an investor requires for holding a stock, compensating them for the associated risk.
• Factors influencing RRR calculation include cost of capital, returns from competing investments, and inflation.
• Investors’ risk tolerance affects their RRR, with retirees generally seeking lower returns compared to risk-tolerant investors.

Investopedia / Jessica Olah

2 Methods to Calculate the Required Rate of Return (RRR)

Calculating the required rate of return can be done using either the dividend discount model (DDM) or the capital asset pricing model (CAPM), chosen based on the specific investment scenario.

Calculating RRR Using the Dividend Discount Model

The dividend discount model is suitable for evaluating equity shares of dividend-paying companies. A popular variant is the Gordon Growth Model, computing RRR based on the stock price, dividend per share, and projected dividend growth rate.

RRR = (Expected dividend payment / Share Price) + Forecasted dividend growth rate

To calculate RRR using the dividend discount model:

• Divide the expected dividend payment by the current stock price.
• Add the result to the forecasted dividend growth rate.

Calculating RRR Using the Capital Asset Pricing Model (CAPM)

The CAPM method employs the asset’s beta, a measure of risk, along with the risk-free rate and market return. This approach is ideal for stocks without dividends.

RRR = Risk-free rate of return + Beta X (Market rate of return – Risk-free rate of return)

To calculate RRR using the CAPM:

• Subtract the risk-free rate from the market rate.
• Multiply by the security’s beta.
• Add the result to the risk-free rate to find the required return.

What Does the Required Rate of Return Tell You?

RRR is a fundamental concept in equity valuation and corporate finance, reflecting varying investment goals, risk preferences, and inflation expectations. It determines a company’s required return, impacted by factors like risk-return preferences and capital structure.

High beta stocks necessitate a higher RRR to compensate for increased risk compared to low beta investments, emphasizing the risk premium in RRR calculations.

RRR is instrumental in project evaluation, aiding in decision-making between projects. The calculation must consider the cost of capital, alternative investment returns, and inflation for accurate analysis.

Example of RRR Using the Dividend Discount Model (DDM)

For instance, if a company is expected to offer a $3 dividend next year, with a 4% annual growth rate, and its stock currently trades at $100 per share:

• RRR = 7% or (($3 expected dividend / $100 per share) + 4% growth rate)

Example of RRR Using the Capital Asset Pricing Model (CAPM)

Assume Company A has a beta of 1.50 while Company B’s beta is 0.50:

• To invest in Company A, RRR = 14% or (2% + 1.50 X (10% – 2%))
• To invest in Company B, RRR = 6% or (2% + 0.50 X (10% – 2%))

Investors evaluating Company A versus Company B would demand a higher RRR for Company A due to its higher beta, illustrating the impact of risk on required returns.

Required Rate of Return vs. Cost of Capital

While RRR influences capital budgeting decisions, it differs from the cost of capital. The cost of capital accounts for debt and equity issuance costs, while RRR sets a benchmark return higher than the cost of capital.

Limitations of the Required Rate of Return

RRR calculations overlook inflation’s impact on investments, as well as individual risk tolerances influencing required returns.

Moreover, the liquidity of an investment isn’t factored into RRR, potentially affecting risk assessments. Comparing stocks across industries can be challenging due to varying risks, highlighting the need to analyze multiple metrics for investment decisions.

What Is the Difference Between the Internal Rate of Return and the Required Rate of Return?

The internal rate of return focuses on the investment’s growth rate, indicating pursuit feasibility if surpassing the minimum required rate of return.

Should the Required Rate of Return Be High or Low?

A high required rate of return signifies higher investment risks, while a low rate indicates lower risks associated with the investment or project.

What Is Considered a Good Return on an Investment?

A good return on investment typically exceeds 7% annually, mirroring the S&P 500’s average annual return adjusted for inflation.

The Bottom Line

Required rate of return guides decision-making on projects, investments, and stock purchases. It serves as a baseline for acceptable returns, considering different risk profiles. Various calculation models exist, but inflation and liquidity are not directly factored into the analysis.