One important use of the required rate of return is in discounting most types of

cash flow models and some relative-value techniques. Discounting different types of
cash flow will use slightly different rates with the same intention: to find the
net present value (NPV).

Common uses of the required rate of return include:

Calculating the present value of dividend income for the purpose of evaluating
stock prices
Calculating the present value of free cash flow to equity
Calculating the present value of operating free cash flow
Analysts make equity, debt, and corporate expansion decisions by placing a value on
the periodic cash received and measuring it against the cash paid. The goal is to
receive more than you paid. Corporate finance focuses on how much profit you make
(the return) compared to how much you paid to fund a project. Equity investing
focuses on the return compared to the amount of risk you took in making the
investment.

Equity and Debt

Equity investing uses the required rate of return in various calculations. For
example, the dividend discount model uses the RRR to discount the periodic payments
and calculate the value of the stock. You may find the required rate of return by
using the capital asset pricing model (CAPM).

The CAPM requires that you find certain inputs including:

The risk-free rate (RFR)

The stock's beta
The expected market return
Start with an estimate of the risk-free rate. You could use the yield to maturity
(YTM) of a 10-year Treasury bill; let's say it's 4%. Next, take the expected market
risk premium for the stock, which can have a wide range of estimates.

The risk-free rate is theoretical and assumes there is no risk in the investment
so it does not actually exist.
For example, it could range between 3% and 9%, based on factors such as business
risk, liquidity risk, and financial risk. Or, you can derive it from historical
yearly market returns. For illustrative purposes, we'll use 6% rather than any of
the extreme values. Often, the market return will be estimated by a brokerage firm,
and you can subtract the risk-free rate.

Or, you can use the beta of the stock. The beta for a stock can be found on most
investment websites.

To calculate beta manually, use the following regression model:

\begin{aligned} &\text{Stock Return} = \alpha + \beta_\text{stock}

\text{R}_\text{market} \\ &\textbf{where:} \\ &\beta_\text{stock} = \text{Beta
coefficient for the stock} \\ &\text{R}_\text{market} = \text{Return expected from
the market} \\ &\alpha = \text{Constant measuring excess return for a}\\
&\text{given level of risk} \\ \end{aligned}

Stock Return=α+β
stock
R
market

where:
β
stock
=Beta coefficient for the stock
R
market
=Return expected from the market
α=Constant measuring excess return for a
given level of risk

βstock is the beta coefficient for the stock. This means it is the covariance
between the stock and the market, divided by the variance of the market. We will
assume that the beta is 1.25.

Rmarket is the return expected from the market. For example, the return of the S&P
500 can be used for all stocks that trade, and even some stocks not on the index,
but related to businesses that are.

Now, we put together these three numbers using the CAPM:

\begin{aligned} &\text{E(R)} = \text{RFR} + \beta_\text{stock} \times (

\text{R}_\text{market} - \text{RFR} ) \\ &\quad \quad = 0.04 + 1.25 \times ( .06
- .04 ) \\ &\quad \quad = 6.5\% \\ &\textbf{where:} \\ &\text{E(R)} =
\text{Required rate of return, or expected return} \\ &\text{RFR} = \text{Risk-free
rate} \\ &\beta_\text{stock} = \text{Beta coefficient for the stock} \\
&\text{R}_\text{market} = \text{Return expected from the market} \\ &(
\text{R}_\text{market} - \text{RFR} ) = \text{Market risk premium, or return above}
\\ &\text{the risk-free rate to accommodate additional} \\ &\text{unsystematic
risk} \\ \end{aligned}

E(R)=RFR+β
stock
×(R
market
−RFR)
=0.04+1.25×(.06−.04)
=6.5%
where:
E(R)=Required rate of return, or expected return
RFR=Risk-free rate
β
stock
=Beta coefficient for the stock
R
market
=Return expected from the market
(R
market
−RFR)=Market risk premium, or return above
the risk-free rate to accommodate additional
unsystematic risk

Dividend Discount Approach

Another approach is the dividend-discount model, also known as the Gordon growth
model (GGM). This model determines a stock's intrinsic value based on dividend
growth at a constant rate. By finding the current stock price, the dividend
payment, and an estimate of the growth rate for dividends, you can rearrange the
formula into:

\begin{aligned} &\text{Stock Value} = \frac { D_1 }{ k - g } \\ &\textbf{where:} \\

&D_1 = \text{Expected annual dividend per share} \\ &k = \text{Investor's discount
rate, or required rate of return} \\ &g = \text{Growth rate of dividend} \\
\end{aligned}

Stock Value=
k−g
D
1

where:
D
1
=Expected annual dividend per share
k=Investor’s discount rate, or required rate of return
g=Growth rate of dividend

Importantly, there needs to be some assumptions, in particular the continued growth

of the dividend at a constant rate. So, this calculation only works with companies
that have stable dividend-per-share growth rates.

Required Rate of Return (RRR) in Corporate Finance

Investment decisions are not limited to stocks. In corporate finance, whenever a
company invests in an expansion or marketing campaign, an analyst can look at the
minimum return these expenditures demand relative to the degree of risk the firm
expended.

Opportunity cost, or the loss of value from not choosing one option, is often
examined when considering the required rate of return (RRR).
If a current project provides a lower return than other potential projects, the
project will not go forward. Many factors—including risk, time frame, and available
resources—go into deciding whether to forge ahead with a project. Typically though,
the required rate of return is the pivotal factor when deciding between multiple
investments.

In corporate finance, when looking at an investment decision, the overall required

rate of return will be the weighted average cost of capital (WACC).

Capital Structure
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is the cost of financing new projects
based on how a company is structured. If a company is 100% debt financed, then you
would use the interest on the issued debt and adjust for taxes, as interest is tax
deductible, to determine the cost. In reality, a corporation is much more complex.

True Cost of Capital

Finding the true cost of capital requires a calculation based on a number of
sources. Some would even argue that, under certain assumptions, the capital
structure is irrelevant, as outlined in the Modigliani-Miller theorem.

According to this theory, a firm's market value is calculated using its earning
power and the risk of its underlying assets. It also assumes that the firm is
separate from the way it finances investments or distributes dividends.
To calculate WACC, take the weight of the financing source and multiply it by the
corresponding cost. However, there is one exception: Multiply the debt portion by
one minus the tax rate, then add the totals. The equation is: