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The required rate of return represents the riskiness of the investment being made; the rate of return will reflect the compensation that the investor receives for the risk borne. The required rate of return is helpful when making decisions regarding the best place for funds to be invested.
The investor also has the option to invest his funds in a number of other investments. The expected rate of return is the return that the investor expects to receive once the investment is made. The expected rate of return can be calculated by using a financial model such as the Capita Asset Pricing Model CAPM , where proxies are used to calculate the return that can be expected from an investment.
The expected rate of return can also be calculated by assigning probabilities to the possible returns that can be obtained from the investment.
The expected rate of return is an assumption, and there is no guarantee that this rate of return will be received.
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. If an investor is considering buying equity shares in a company that pays dividends, the dividend discount model is ideal. A popular variation of the dividend discount model is also known as the Gordon Growth 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:. To calculate RRR using the dividend discount model:. 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.
Beta is the risk coefficient of the holding. In other words, beta attempts to measure the riskiness of a stock or investment over time. The formula also uses the risk-free rate of return, which is typically the yield on short-term U. Treasury securities. The required rate of return RRR is a key concept in equity valuation and corporate finance. It's a difficult metric to pinpoint due to the different investment goals and risk tolerances of individual investors and companies.
Each one of these and other factors can have major effects on a security's intrinsic value. 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.
In other words, RRR is in part calculated by adding the risk premium to the expected risk-free rate of return to account for the added volatility and subsequent risk. For capital projects, RRR is useful in determining whether to pursue one project versus another. The RRR is what's needed to go ahead with the project although some projects might not meet the RRR but are in the long-term best interests of the company.
To accurately calculate the RRR and make it more meaningful, the investor must also consider their cost of capital, as well as the return available from other competing investments.
In addition, inflation must also be factored into RRR analysis so as to obtain the real or inflation-adjusted rate of return. In the capital asset pricing model CAPM , RRR can be calculated using the beta of a security, or risk coefficient, as well as the excess return that investing in the stock pays over a risk-free rate called the equity risk premium.
Assume the following:. Let's say Company A has a beta of 1. Company B has a beta of 0. Thus, an investor evaluating the merits of investing in Company A versus Company B would require a significantly higher rate of return from Company A because of its much higher beta. Although the required rate of return is used in capital budgeting projects, RRR is not the same level of return that's needed to cover the cost of capital.
The cost of capital is the minimum return needed to cover the cost of debt and equity issuance to raise funds for the project.
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