Required Rate of Return

PRESENTED BY AMAL KRISHNA CHANDRAN

What is Required Rate of Return

 The required rate of return(RRR) is the minimum return an investor will accept

for owning a company's stock, as compensation for a given level of risk
associated with holding the stock. The RRR is also used in corporate finance to
analyze the profitability of potential investment projects.
Key Takeaways

To accurately calculate the RRR and improve its utility, the investor must also consider his
or her cost of capital, the return available from other competing investments, and inflation.
The RRR is a subjective minimum rate of return; this means that a retiree will have a lower
risk tolerance and therefore accept a smaller return than an investor who recently
graduated college and may have a higher appetite for risk.
The RRR is also known as the hurdle rate, which like RRR, denotes the appropriate
compensation needed for the level of risk present. Riskier projects usually have higher
hurdle rates, or RRRs, than those that are less risky.
Methods for Calculation

 There are a couple of ways to calculate the required rate of return—either using the
dividend discount model (DDM), or the capital asset pricing model (CAPM). The choice
of model used to calculate the RRR depends on the situation for which it is being used.
 The Two Methods are as follows
 Calculating Required Rate of Return (RRR) Using the Dividend Discount Model
 Calculating Required Rate of Return (RRR) Using the Capital Asset Pricing Model (CAPM)
Calculating Required Rate of Return (RRR)
Using the Dividend Discount Model

The dividend-discount model calculates the RRR for equity of a dividend-paying stock by
utilizing the current stock price, the dividend payment per share, and the forecasted
dividend growth rate. The formula is as follows:
RRR =  (Expected dividend payment / Share Price) + Forecasted dividend growth rate    
To calculate RRR using the dividend discount model:

•Take the expected dividend payment and divide it by the current stock price.

•Add the result to the forecasted dividend growth rate.

Calculating Required Rate of Return (RRR)
Using the Capital Asset Pricing Model (CAPM)

 Another way to calculate RRR is to use the capital asset pricing model (CAPM), which is typically
used by investors for stocks that do not pay dividends.
The formula for RRR using the CAPM model is as follows:

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 of return from the market rate of return.

Multiply the above figure by the beta of the security.

Add this result to the risk-free rate to determine the required rate of return.
What Does the Required Rate of Return
(RRR) Tell You?

 The required rate of return RRR is a key concept in equity valuation and corporate
finance.
 For investors using the CAPM formula, the required rate of return for a stock with a high
beta relative to the market should have a higher RRR. The higher RRR relative to other
investments with low betas is necessary to compensate investors for the added level of
risk associated with investing in the higher beta stock.
 For capital projects, RRR is useful in determining whether to pursue one project versus
another.
Limitations of Required Rate of Return (RRR)

 The RRR calculation does not factor in inflation expectations since rising prices erode
investment gains. However, inflation expectations are subjective and can be wrong.
 RRR will vary between investors with different risk tolerance levels. A retiree will have a
lower risk tolerance than an investor who recently graduated college. As a result, the
RRR is a subjective rate of return.
 RRR does not factor in the liquidity of an investment. If an investment can't be sold for a
period of time, the security will likely carry a higher risk than one that's more liquid.
THANK YOU