Required Rate of Return,abbreviated as RRR,refers to the minimum rate of return that an investor expects or demands in order to undertake a specific investment. In other words,it is the compensation that an investor expects to receive for being willing to bear the risks associated with an investment. Expected return is the predicted rate of return that an asset may achieve in the future under uncertain conditions. The inherent risk of an investment or project is determined by its required rate of return. Therefore,a higher RRR indicates a higher risk,while a lower RRR indicates a lower risk. If the expected return of an investment is lower than the required rate of return,then the investor will not consider the investment.
How to Calculate RRR
1.The Capital Asset Pricing Model (CAPM)
Required Rate of Return = Risk-Free Rate + β * (Market Return - Risk-Free Rate)
Risk-Free Rate: Typically represented by the yield on government bonds.
β (Beta): A measure of an asset's volatility relative to the overall market. A higher beta value indicates a higher risk for the asset.
Market Return: Typically represented by the return on a stock market index.
2.Bond Yield Plus Risk Premium Approach
This method is suitable for assessing the required rate of return for bonds or bond-like investments.
Required Rate of Return = Bond Yield + Risk Premium
Bond Yield: Refers to the yield to maturity of the bond.
Risk Premium: Determined based on factors such as the bond's credit rating and maturity.
3.Dividend Discount Model (DDM)
DDM is suitable for evaluating the required rate of return for stocks.
Required Rate of Return = (Next Expected Dividend / Current Stock Price) + Dividend Growth Rate
Next Expected Dividend: Refers to the investor's expectation for the next dividend payment.
Current Stock Price: Refers to the current market price of the stock.
Dividend Growth Rate: Refers to the investor's expectation for the future dividend growth rate.
Other Factors Affecting the RRR
Liquidity: Assets with lower liquidity typically require a higher required rate of return to compensate investors for the risk that the asset may be difficult to sell when needed.
Taxes: Taxes reduce the investor's actual return. Therefore, investments with higher taxes usually require a higher required rate of return to offset the impact of taxes.
Investment Horizon: The longer the investment horizon, the greater the uncertainty faced by the investor, so a higher required rate of return is usually required.
Market Sentiment: Market sentiment can also affect the required rate of return. When market sentiment is optimistic, investors may be willing to accept a lower required rate of return; when market sentiment is pessimistic, investors may demand a higher RRR.
Through the RRR, investors can decide whether to expand or undertake new investments or purchase stocks of a certain company. The RRR determines the inherent risks of an investment, and it can vary between investors with different risk tolerance levels. Compared to the costs and returns of other similar investment opportunities, the RRR can serve as a benchmark for the minimum acceptable return.
