Wednesday, 18 January 2012

Required Rate of Return Method

Required Rate of Return Definition: The required rate of return, defined as the minimum return the investor will accept for a particular investment, is a pivotal concept to evaluating any investment. The required rate of return is supposed to compensate the investor for the riskiness of the investment. If the expected return of an investment does not meet or exceed the required rate of return, the investor will not invest. The required rate of return is also called the hurdle rate of return.
Required Rate of Return Explanation:
Required rate of return, explained simply, is the key to understanding any investment. This essentially requires determining the investor’s cost of capital. The investment will be attractive as long as the expected returns on the project or investment exceed the cost of capital. The cost of capital can be the cost of debt, the cost of equity, or a combination of both.

If the investor is a company considering the required rate of return on a corporate project, then calculating the cost of debt is simple. It is the interest rates on the company’s debt obligations. If the company has numerous differing debt obligations, then the cost of debt is the weighted average of those interest rates.

Calculating the cost of equity can be done using the capital asset pricing model(CAPM). It can also be estimated by finding the cost of equity of projects or investments with similar risk. Like with the cost of debt, if the company has more than one source of equity – such as common stock and preferred stock – then the cost of equity will be a weighted average of the different return rates.

Required Rate of Return Formula:
The core required rate of return formula is:

Required rate of return = Risk-Free rate + Risk Coefficient(Expected Return - Risk-Free rate)

Required Rate of Return Calculation:
Required rate of return calculations appear more complicated than they actually are. Using the formula above:

Required rate of Return = .07 + 1.2($100,000 - .07) = $119,999.99

Risk-Free rate = 7%
Risk Coefficient = 1.2
Expected Return = $100,000

Weighted Average Cost of Capital (WACC):
Combining the cost of equity and the cost of debt in a weighted average will give you the company’s weighted average cost of capital, or WACC. This rate can be considered the required rate of return, or the hurdle rate of return, that the proposed project’s return must exceed in order for the company to consider it a viable investment.

Required Rate of Return for Investments:
In terms of investments, like stocks, bonds, and other financial instruments, the required rate of return refers to the necessary expected return on the investment needed by the investor in order for him to consider investing. This rate can be based on investments with similar risk, or it can be the rate of the investor’s next best alternative investment opportunity.

For example, if an investor has his money in a savings account earning 5% annual interest, and he is considering investing in a risk-free treasury bond, then he might say the required rate of return on assets for such an investment is 5%. The treasury bond must yield more than 5% per year for the investor to consider taking his money out of the savings account and investing it in the bond. In this case, 5% would be the investor’s required rate of return.

Required Rate of Return Example:
Joey works for himself as a professional stock investor. His work, highly analytical, is a perfect fit for him. Joey prides himself on his ability to evaluate where the market is and where it will be.

Joey knows his next investment option is high-stakes and risky. He wants to know his required rate of return on equity for a stock he is thinking about investing in. Joey performs the calculation below to find his answer:

Required rate of Return = .07 + 1.2($100,000 - .07) = $119,999.99
If:Risk-Free rate = 7%
Risk Coefficient = 1.2
Expected Return = $100,000

Joey decides that his investment is not a good decision because his required rate of return is quite high. He resolves to find less risky decisions in order to protect the success he has already created. Without calculating his required rate of return on stock Joey could have ruined everything that he has created so far. Joey uses this experience to humble himself as he moves forward.

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