The Bottom Line

When dealing with corporate decisions to expand or take on new projects, the
required rate of return (RRR) is used as a benchmark of minimum acceptable return,
given the cost and returns of other available investment opportunities.

Depending on the factors being evaluated, different models can help arrive at the
required rate of return (RRR) for an investment or project.

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Related Terms
Internal Rate of Return (IRR)
The internal rate of return (IRR) is a metric used in capital budgeting to estimate
the return of potential investments. more
Accounting Rate of Return (ARR) Definition
The accounting rate of return (ARR) measures the amount of profit, or return,
expected on investment as compared with the initial cost. more
How to Use Required Rate of Return – RRR to Evaluate Stocks
The required rate of return (RRR) is the minimum return an investor will accept for
an investment as compensation for a given level of risk. more
How to Calculate the Weighted Average Cost of Capital – WACC
The weighted average cost of capital (WACC) is a calculation of a firm's cost of
capital in which each category of capital is proportionately weighted. more
Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a valuation method used to estimate the
attractiveness of an investment opportunity. more
Market Risk Premium
Market risk premium is the difference between the expected return on a market
portfolio and the risk-free rate. it is an important element of modern portfolio
theory and discounted cash flow valuation. more
The capital asset pricing model (CAPM) and the security market line (SML) are used
to gauge the expected returns of securities given levels of risk. The concepts were
introduced in the early 1960s and built on earlier work on diversification and
modern portfolio theory.1 Investors sometimes use CAPM and SML to evaluate a
security—in terms of whether it offers a favorable return profile against its level
of risk—before including the security within a larger portfolio.

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a formula that describes the relationship
between the systematic risk of a security or a portfolio and expected return. It
can also help measure the volatility or beta of a security relative to others and
compared to the overall market.

KEY TAKEAWAYS
Any investment can be viewed in terms of risks and return.
The CAPM is a formula that yields expected return.
Beta is an input into the CAPM and measures the volatility of a security relative
to the overall market.
SML is a graphical depiction of the CAPM and plots risks relative to expected
returns.
A security plotted above the security market line is considered undervalued and one
that is below SML is overvalued.
Mathematically, the CAPM formula is the risk-free rate of return added to the beta
of the security or portfolio multiplied by the expected market return minus the
risk-free rate of return:

\begin{aligned} &\text{Required Return} = \text{RFR} + \beta_\text{stock/portfolio}

\times ( \text{R}_\text{market} - \text{RFR} ) \\ &\textbf{where:} \\ &\text{RFR} =
\text{Risk-free rate of return} \\ &\beta_\text{stock/portfolio} = \text{Beta
coefficient for the stock or portfolio} \\ &\text{R}_\text{market} = \text{Return
expected from the market} \\ \end{aligned}

Required Return=RFR+β
stock/portfolio
×(R
market
−RFR)
where:
RFR=Risk-free rate of return
β
stock/portfolio
=Beta coefficient for the stock or portfolio
R
market
=Return expected from the market
The CAPM formula yields the expected return of the security. The beta of a security
measures the systematic risk and its sensitivity relative to changes in the market.
A security with a beta of 1.0 has a perfect positive correlation with its market.
This indicates that when the market increases or decreases, the security should
increase or decrease by the same percentage amount. A security with a beta higher
than 1.0 carries greater systematic risk and volatility than the overall market,
and a security with a beta less than 1.0, has less systematic risk and volatility
than the market.

Security Market Line

The security market line (SML) displays the expected return of a security or
portfolio. It is a graphical representation of the CAPM formula and plots the
relationship between the expected return and beta, or systematic risk, associated
with a security. The expected return of securities is plotted on the y-axis of the
graph and the beta of securities is plotted on the x-axis. The slope of the
relationship plotted is known as the market risk premium (the difference between
the expected return of the market and the risk-free rate of return) and it
represents the risk-return tradeoff of a security or portfolio.