Understanding the Required Rate of Return: A Key Finance Concept

The required rate of return (hurdle rate) is the minimum return that an investor is expecting to receive for their investment. Essentially, the required rate is the minimum acceptable compensation for the investment’s level of risk.

The required rate of return is a key concept in corporate finance and equity valuation. For instance, in equity valuation, it is commonly used as a discount rate to determine the present value of cash flowsNet Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present..

Required Rate of Return in Investing

The required rate is commonly used as a threshold that separates feasible and unfeasible investment opportunities. The general rule is that if an investment’s return is less than the required rate, the investment should be rejected.

The metric can be adjusted for the needs and goals of a particular investor. It can consider specific investment goals, as well as risk and inflation expectations.

How to Calculate the Required Rate of Return?

There are different methods of calculating a required rate of return based on the application of the metric.

One of the most widely used methods of calculating the required rate is the Capital Asset Pricing Model (CAPM)FinanceCFI's Finance Articles are designed as self-study guides to learn important finance concepts online at your own pace. Browse hundreds of articles!. Under the CAPM, the rate is determined using the following formula:

RRR = r_f + ß(r_m – r_f)

Where:

• RRR – required rate of return
• r_f – risk-free rate
• ß – beta coefficient of an investment
• rm – return of a market

The CAPM framework adjusts the required rate of return for an investment’s level of risk (measured by the betaBetaThe beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.) and inflation (assuming that the risk-free rate is adjusted for the inflation level).

Another method of calculating the required rate is the Weighted Average Cost of Capital (WACC)WACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.. The WACC approach is frequently utilized in corporate finance. Unlike the CAPM, the WACC takes into consideration the capital structure of a company. Due to this, the required rate obtained from the WACC is used in the corporate decision-making process of undertaking new projects. It can be calculated using the following formula:

RRR = w_Dr_D(1 – t) + w_er_e

Where:

• w_D – weight of debt
• r_D – cost of debt
• t – corporate tax rate
• w_e – weight of equity
• r_e – cost of equity

The WACC determines the overall cost of the company’s financing. Therefore, the WACC can be viewed as a break-even return that determines the profitability of a project or an investment decision.

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading
• Discount FactorDiscount FactorIn financial modeling, a discount factor is a decimal number multiplied by a cash flow value to discount it back to the present value. 
• Market Risk PremiumMarket Risk PremiumThe market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets.
• Return on Equity (ROE)Return on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity.