What is a Required Rate Of Return - RRR
The required rate of return, also known as the hurdle rate, is the minimum return an investor will accept for an investment or project, that compensates them for a given level of risk. In equity valuation, it is equal to the weighted average cost of capital, and is used to value stocks using discounted cash flow analysis. It is also used in corporate finance to analyze the profitability of potential investment projects.
Required Rate Of Return
BREAKING DOWN Required Rate Of Return - RRR
The required rate of return (RRR) is a key concept in equity valuation and corporate finance. But it is a difficult metric to pinpoint due to the different investment goals and risk tolerance of individual investors and companies. Risk-return preferences, inflation expectations and a company’s capital structure all play a role in determining the required rate. Each one of these, and other factors, can have major effects on a security's intrinsic value.
Required Rate of Return Formula
In the capital asset pricing model (CAPM), the RRR is calculated using the following formula, where the beta of the security is the risk coefficient, and where the excess return that investing in the stock market provides over a risk-free rate is the equity risk premium.
Required rate of return = risk-free rate + beta of the security (expected market return – risk free rate)
The RRR on a stock is the minimum rate of return on a stock that an investor considers acceptable, taking into account their cost of capital, inflation and the return available on other investments. For example, if inflation is 3% per year, and the equity risk premium over the risk-free return (a US Treasury bond which returns 3%), then an investor might require a return of 9% per year to make the stock investment worthwhile. This is because a 9% return is really a 6% return after inflation – which means the investor would not be rewarded for the risk they were taking. They would receive the same risk-adjusted return by investing in the 3% yielding Treasury bond (whose real rate of return after adjusting for inflation would be zero).
RRR in Equity Valuation
The RRR is used to calculate a company's net present value of a company's future cash flows — and the value of the business — in discounted cash flow analysis; where the RRR is the weighted average cost of capital (WACC). WACC can also be used as a hurdle rate against which to assess return on invested capital (ROIC) performance. It also plays a key role in economic value added (EVA) calculations.
RRR in Project Evaluation
The RRR is used in capital budgeting – where it functions as the discount rate – to evaluate the profitability of a new project or business expansion. A new project is profitable and should be pursued if the internal rate of return (IRR) is greater than the minimum required rate of return, which is the company’s WACC. Thus, the RRR is the cost of capital at which a project breaks even – where the net present value of the project's future cash flows is greater than the cost of financing the capital investment.
Dividend Discount Approach
An investor can also use the dividend-discount model, also known as the Gordon growth model, to calculate the RRR for equity of a dividend-paying stock. By finding the current stock price, the dividend payment and an estimate of the growth rate for dividends, you can rearrange the formula into:
k = required rate of return
D = dividend payment (expected to be paid next year)
S = current stock value (if using the cost of newly issued common stock you will need to minus the flotation costs)
g = growth rate of the dividend
For example, suppose a company is expected to pay an annual dividend of $3 next year and its stock is currently trading at $100 a share. The company has been steadily raising its dividend each year at a 4 percent growth rate. The company’s required rate of return is (($3/$100) + 0.06), or 9 percent.