Required Rate of Return

The required rate of return is the lowest return an investor or a business will accept for putting money into a particular investment, given its risk. If an investment is expected to earn less than the required rate, it is not worth making, because the investor could earn at least that much elsewhere for a similar level of risk. The required rate is therefore a measure of opportunity cost.

The concept is used in two closely related ways. Investors use it to decide whether a share or bond is fairly priced. Companies use it to evaluate projects, where it is often called the hurdle rate and is usually based on the firm's cost of capital. In both cases it serves as the discount rate for converting future cash flows to a present value.

A required rate of return has two basic parts: compensation for waiting and compensation for risk.

• The risk-free rate, usually measured by the yield on US Treasury securities, compensates for the time value of money and expected inflation.
• A risk premium compensates for the chance that actual returns will be lower than expected. Riskier investments, such as small company shares or projects in new markets, need higher premiums.
• Other factors, such as poor liquidity, currency risk or country risk, may add further premiums.

For shares, the most widely taught approach is the capital asset pricing model (CAPM):

• $r$ is the required rate of return on the share.
• $r_{f}$ is the risk-free rate.
• $\beta$ is the share's beta, a measure of how strongly it moves with the overall market.
• $r_{m} - r_{f}$ is the market risk premium, the extra return expected from the stock market as a whole over the risk-free rate.

Suppose the risk-free rate is 4 percent, the market risk premium is 5.5 percent and a company's beta is 1.2. The required return on its shares is 4 plus 1.2 times 5.5, or 10.6 percent. If an analyst expects the shares to return 9 percent a year at the current price, they look overpriced; if the expected return is 13 percent, they look attractive. The dividend discount model can also be rearranged to estimate the required return from the current dividend yield plus expected dividend growth.

In capital budgeting, the company discounts a project's expected cash flows at its required rate. A project costing $500,000 that will produce $150,000 a year for five years has a net present value of about $68,600 at a 10 percent required rate, so it should be accepted. At 16 percent the net present value is about minus $8,900, so it should be rejected. Equivalently, the project's internal rate of return, about 15.2 percent, must exceed the required rate.

Companies usually start with the weighted average cost of debt and equity and then adjust it for the risk of the particular project. A safe cost-saving project may use a lower rate than the company average, while a new venture in an unfamiliar market should use a higher one.

The required rate of return is an estimate, not an observed figure. Betas change over time and depend on the period and index used, and estimates of the market risk premium vary between about 4 and 7 percent among practitioners. Small changes in the rate can swing valuations widely, particularly for long-lived projects or growth companies whose cash flows are far in the future. Using a single company-wide rate for all projects can also lead firms to take on too many risky projects and reject safe ones.