Once you have calculated the Net Present Value (NPV) of an investment project or opportunity, one of the last steps in the process is to calculate the required rate of return (also known as the discount rate). In this article, we’ll break down what exactly this value represents and how to calculate it in three simple steps
Introduction
The required rate of return is the minimum acceptable return on an investment. In other words, it is the minimum return that investors expect for investing in a company or project.
Components of Required Rate of Interest
- Time Value of Money– The required rate of return is the minimum percentage of return that an investor will accept for investing in a project or security.
The time value of money indicates the concept that money today will always have more value than money in the future. In order to calculate the required rate of return, you must first determine the time value of money.
This can be done by using a discount rate or an interest rate. The discount rate indicates the rate at which the discount future cash flows back to their original value.
- Risk Involved– The required rate of return must also compensate investors for taking on risk. The required rate of return compensates the investor for three types of risk: business risk, financial risk, and personal risk.
3) The expected rate of inflation during the investment period– In order to calculate the required rate of return, it is essential to know the expected rate of inflation when you are investing.
The expected rate of inflation is the percentage change in prices that is anticipated over a given period of time. For example, if the current inflation rate is 2% and you expect it to remain at that level for the next year, then your expected rate of inflation would be 2%.
Required Rate of Return- Step by step calculation
There are several ways to calculate the required rate of return—one of which is using the dividend discount model (DDM), or the capital asset pricing model (CAPM). The choice of model used to calculate RRR depends on the situation for which it is being used.
Calculating Required Rate of Return (RRR) Using the Dividend Discount Model
The dividend discount model (DDM) is an investment valuation model that calculates the present value of a company’s future dividends based on growth and risk characteristics. Investors use this to determine their required rate of return (RRR). To calculate
RRR = (Expected dividend payment / Share Price) + Forecasted dividend growth rate
Calculating Required Rate of Return (RRR) Using the Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is the ideal model used to determine the required rate of return on an investment based on your personal risk tolerance and on the expected market returns. A good way to get started with this calculation is to use the rule of thumb that your required rate of return should be 8-10 percent higher than the expected market return before taxes. Here’s how you can calculate your personal required rate of return using CAPM in just few steps
RRR = Risk-free rate of return + Beta X (Market rate of return – Risk-free rate of return)
- Market rate of return can be calculated by subtracting the risk free rate.
- However, the product obtained by subtracting the two values should be multiplied by the Beta.
- The final step to calculate the required rate of interest is to add this result to the risk free rate of return.
What does Required Rate of Interest on Bond Means?
The required rate of return on a bond, also known as the yield to maturity, indicates how much return an investor can expect to receive from that bond over time.
This information is necessary in order to value bonds, which are used by investors and companies in order to raise capital. The required rate of return on a bond serves as one of the most important variables in the process of selecting securities, and it is crucial that it be calculated properly and carefully considered when making purchasing decisions.
Interpretation of Required Rate of Interest
The required rate of interest (RRI) refers to the minimum return that investors need to receive on an investment in order to take the risk of investing in that particular project or company.
The financial return that investors expect depends on the size of the capital investment required and the perceived risk of investing in that particular project or company.
A high RRI indicates a high perceived risk, while a low RRI indicates a low perceived risk. The required rate of interest can be calculated with the following formula: RRI = Capital Cost x Risk Premium + (Operating Profit – Normal Profit).
Examples of Required Rate of Return
There are various examples of the required rate of return. Some of them are-
Example 1: What Is the Required Rate of Return on Your Pension Fund?
Your pension fund’s required rate of return is the percentage it needs to earn on its investments each year to cover expenses and pay you the benefits you’ve been promised.
For example, if your pension fund has a $1 million balance and an annual payout of $50,000, it will need to earn at least a 5% return on its investments each year to keep up with its obligations
Limitation of Required Rate of Return
Despite its seeming importance, the required rate of return can have limitations. These limitations are highlighted below:
- When calculating the required rate of return, inflation expectations can be subjective. Most of the time, inflation expectations are not accounted for in the calculation of required rates of return.
- Liquidity of investment is another factor that RRR does not consider.
- RRR may have varying results depending on the tolerance levels of various individuals and investors.
Conclusion
To conclude the required rate of return is a hurdle rate for investors to forecast the degree of profitability of their investment project. This hurdle rate will show the level of profitability from their investment project in order to make it a worthwhile endeavor. If this hurdle rate cannot be obtained, then a project cannot be expected to create adequate value if it is pursued.
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