One of the key concepts in corporate finance is the required rate of return. Among the many metrics utilized by finance professionals, required rate of return is a keystone concept that drives many other calculations. Understanding required rate of return is critical for understanding the basis for many other financial calculations that utilize a discount rate.
In this FAQ we will cover what the required rate of return is, why it is important, how it is used by corporate finance professionals as well as individual investors, and how it is calculated.
What Is Required Rate Of Return (RRR)?
Required rate of return is the minimum return an investor is willing to accept for assuming the risk of making an investment. Unlike many other financial metrics, required rate of return is often an arbitrary number that is not derived formulaically but is created through the personal risk-reward appetite of the individual or individuals making an investment. This is not to say you cannot calculate a required rate of return but that often it is not derived mathematically.
The concept is considered a foundational concept in corporate finance and valuation because of its wide application in many other financial calculations. It acts as a threshold that defines which investments are feasible and which are not. In general, if an investment does not yield a return equal to, or greater than, the required rate of return it should not be pursued.
Why Is Required Rate Of Return Important?
The required rate of return is used throughout the finance field to assist in analyzing various types of investments and valuing assets. Depending on the sector that is using the metric, it has different uses.
For example, in investment management, the required rate of return is often called the “preferred return” and acts as a hurdle rate that investment managers must first achieve before earning incentive allocations. This incentivizes investment managers to identify investment opportunities that will produce better results than the minimum required by investors.
In corporate finance, the required rate of return is often used to compare multiple projects at one time. This helps finance departments select projects that will return the most value for the amount of risk that the organization is assuming in pursuing the project.
Finally, in asset valuation, the required rate of return is used in various types of calculations that help to discount future value to present value. Often referred to as the discount rate, it is used in discounted cash flow (DCF) valuations and is also used in Net Present Value (NPV) calculations.
How To Calculate Required Rate Of Return
There are various ways to calculate the required rate of return. The two most common methods are Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM).
Calculating Required Rate Of Return Using CAPM
The capital asset pricing model is a model that helps to define the relationship between what the return that an investor is expecting to receive based on the level of risk associated with the investment. It essentially illustrates that the expected return of a security is equal to the risk-free rate plus some premium for assuming the risk of making the investment. The risk is assessed with a metric known as “Beta”.
Beta is a metric that helps to define the volatility of an asset without taking into account its leverage. It essentially compares the level of risk of investing in a single company against investing in the overall market.
The formula for calculating required rate of return under the capital asset pricing model is:
- RRR is the required rate of return
- rf is the risk-free rate or treasury rate
- rmis the market return
- is the beta coefficient of the investment
Calculating Discount Rate Using WACC
Weighted Average Cost of Capital is often used to calculate enterprise value. The calculation takes into consideration COGS against inventory, and layers in common stock, preferred stock, bonds, and all other long-term debt.
WACC is a combination of the cost of equity and the after-tax cost of debt. The calculation is made by multiplying the cost of each capital source by its respective weight in the capital structure.
Since the required rate of return is a component of the WACC formula, the formula can be modified and used to identify the required rate of return.
The formula for calculating required rate of return using the WACC formula is:
- WACC is the discount rate or required rate of return
- E is the value of Equity
- D is the value of Debt
- Ceis the Cost of Equity
- Cdis the Cost of Debt
- V = (D+E)
- T is the effective tax rate
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