Required Rate Of Return
The required rate of return (RRR) is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.The RRR is also known as the hurdle rate, which like RRR, denotes the appropriate compensation needed for the level of risk present. Riskier projects usually have higher hurdle rates, or RRRs, than those that are less risky.
Definition: The required rate of return (RRR) is the minimum return an investor is willing to accept for holding a company's stock, as compensation for the risk taken. It is also used in corporate financial analysis to assess the profitability of potential investment projects. The RRR is also known as the hurdle rate, indicating the appropriate compensation for the level of risk. Higher-risk projects typically have higher hurdle rates or RRRs, while lower-risk projects have lower rates.
Origin: The concept of the RRR originates from modern investment theory, particularly the Capital Asset Pricing Model (CAPM). CAPM was introduced by William Sharpe in the 1960s to explain and predict the expected return of assets. The CAPM model calculates the RRR by considering the risk-free rate, market risk premium, and the asset's beta coefficient.
Categories and Characteristics: The RRR can be classified based on different investment objects and risk levels.
- Stock RRR: Usually calculated using the CAPM model, considering market risk and individual stock risk.
- Bond RRR: Mainly considers credit risk and interest rate risk.
- Project Investment RRR: Used by companies when evaluating new projects, typically compared with the internal rate of return (IRR).
- Risk Compensation: The RRR reflects the investor's requirement for risk compensation.
- Dynamic Nature: The RRR changes with market conditions and risk levels.
Specific Cases:
- Case 1: Suppose an investor is considering investing in a tech company's stock. Using the CAPM model, the RRR for this stock is calculated to be 10%. If the expected return of the stock is below 10%, the investor may choose not to invest, as the return does not adequately compensate for the risk taken.
- Case 2: A company plans to invest in a new project with an expected internal rate of return (IRR) of 12%. If the company's RRR is 15%, the project may be rejected because its expected return does not meet the RRR.
Common Questions:
- How is the RRR calculated? It is usually calculated using the CAPM model, with the formula: RRR = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
- What is the difference between RRR and expected return? The RRR is the minimum return an investor expects, while the expected return is an estimate of future returns.
