What is a 'Required Rate Of Return - RRR'
The required rate of return (RRR) is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. The RRR is used in both equity valuation and in corporate finance. Investors use the RRR to decide where to put their money, and corporations use the RRR to decide if they should pursue a new project or business expansion.
BREAKING DOWN 'Required Rate Of Return - RRR'Using the RRR, investors compare the return of an investment to all other available options, taking into consideration the risk-free rate of return, inflation and liquidity. The RRR, part of the dividend discount model to pick stocks, affects the maximum price investors are willing to pay for a stock. Corporations also use RRR to calculate net present value in discounted cash flow analysis. In corporate finance, the RRR is equal to the weighted average cost of capital (WACC).
An investor might require a return of 9% per year to consider a stock investment worthwhile, assuming it is easy to sell the stock and that inflation is 3% per year. The reasoning is that if the investor does not receive a 9% return, which is really a 6% return after inflation, it would be better putting the money in a CD that earns a risk-free 3% per year, which is really 0% after inflation. An investor is not willing to take on the additional risk of investing in stocks, which can be volatile and whose returns are not guaranteed, unless there is a 6% premium over the risk-free CD. The RRR is different for individuals and companies, depending on their risk tolerance, investment goals and other unique factors.
RRR in Equity Valuation
The RRR functions as the discount rate in equity investment valuation; future dividend payments are discounted by an investor's RRR to their present value, the equivalent of the equity investment's fair price to the investor. If the equity investment's market price is lower than the fair present value, the investor may deem the equity investment worthwhile. An investor would also take a direct look at the equity investment's expected rate of return and compare it to the RRR. If the future rate of return on the equity investment is expected to be greater than the RRR, the equity investment would be justified to the investor.
RRR in Project Evaluation
The RRR also functions as the discount rate in business project evaluation, as future cash flows from a business project are discounted to their present value by a company's RRR. If the present value of the project's future cash flows is greater than the amount of the project's capital investment, the project would generate positive returns after covering the financing cost of the investment capital. In corporate finance, the RRR is compared to a company's internal rate of return (IRR), the highest allowable cost of capital at which a project breaks even. To have a profitable project, the RRR, a cost proxy, should not exceed the IRR, the return proxy.