For an individual deciding to invest his savings, the decision on where to invest is quite tricky. He may choose to invest in shares, bonds, stocks, and many other options. However, for a new investor, choosing the bond option is beneficial as no expert analysis is required for it, and being definite investments, it carries little risk.
Since bonds are low-risk investments, the return from them is also low. On the other hand, stocks carry higher risk due to price fluctuations but give a higher return. Its market is highly volatile. So, the more you risk your saving, the higher benefit you get.
Required Rate of Return (RRR)
Due to the high return in stocks, people tend to choose this investment more. However, to make your investment fruitful, you need to predict the potential gains. The required rate of return (RRR) is one of the methods to calculate this return.
“Required Rate of return is the minimum acceptable rate of earnings required by individuals or businesses willing to take an investment opportunity.”
Computing the required rate of return helps you set a threshold below which the investment is discarded. Thus, this rate is a guide while choosing between investment options.
Factors that make Required Rate of Return investor specific
Three factors make this rate unique for each investor. These are:
- Risk tolerance levels
- Investment goal
- Duration of investment
Risk tolerance levels- As the name suggests defines the ability of an investor to undertake risk.
Investment Goal- It is the outcome an investor may expect from his investment. Understanding the industry and market is required to decide if a specific investment fulfills your investment goal.
Duration of investment- The period you may want to keep your money invested is another crucial factor in deciding where to invest. This decision is dependent on the investment goal.
Factors that influence the Required Rate of Return
Factors of investment that affect the required rate of return are
Risk- It differs from investment to investment. Some carry high risk while some are very low at risk. Investment may be made in negative return bonds of government, also considering it more secure.
Inflation- Inflation rate is directly proportional to the required rate of return means the higher inflation, the greater the RRR.
Liquidity- The higher the period an investment takes to give a return on it, the less liquid it is and will result in higher the rate of return.
The required rate of return VS Expected rate of return
These two terms may be confused with each other. The table below explains the difference between them.
|The required rate of return (RRR)||Expected rate of return (ERR)|
|Minimum possible return you require.||The return on investment you expect.|
|It is a threshold.||It is not a threshold rather an expectation from investment.|
|Determining factor||Possibility factor|
Because of the volatility in the market, the required and expected rate of returns are not guaranteed. An investor may achieve a higher or lower return than what was predicted.
How to calculate the Required Rate of Return?
There are several methods to arrive at the required rate of return. These are
- Dividend Discount Model
- Capital Asset Pricing Model
- Weighted Average Cost of Capital
1. Dividend Discount Model
Also known as the Gordon Growth Model, this model is used for the investment made in shares. This model undertakes an assumption that the “dividend payout grows at a constant rate.”
RRR = (Expected dividend payment / Current share price) + Dividend growth rate
A company AB Ltd pays its shareholders a dividend with a growth rate of 5%. Next year, it is predicted that a dividend of $3 per share will be paid. The company’s current stock trading price is $80.
RRR = (3 / 80) + 0.05
= 0.0875 or 8.75%
Since this model does not consider the effect of inflation, the actual rate of return may be different when there is inflation in the market. Assuming the inflation is 2 percent, the actual return will be 6.75% instead of 8.75%.
2. Capital Asset Pricing Model
This is the most widely used model. It is used for investments that do not generate dividends. The rate of return is arrived at using the following formula.
RRR = Rf + β (Rm – Rf)
Rf – Risk-free rate
β – beta coefficient of an investment
Rm – market return
Beta being the risk coefficient of investment, measures the risk of an investment carry or investment’s volatility compared to the market return. The beta of the market is 1. Stocks more volatile than the market have a β greater than 1.0. Similarly, the stock that changeless as compared to the market has a β of less than 1.0.
A Company XY has a β of 1.2. The return on the market is 5%. The bank’s interest rate on saving accounts is 1.5%, while the government securities carry a 2% rate.
RRR = 0.02 + (1.2 (0.05 – 0.02))
= 0.56 or 5.6%
There are some benefits and limitations of this approach.
|Easy to use and understand.||It does not cover all risks associated with the investment.|
|Systematic risk is accounted for.||It does not evaluate reasonable returns correctly.|
|Assumption of lending and borrowing at the risk-free rate.|
|Returns calculated are past returns and may not reflect future returns accurately.|
|It does not take into consideration the capital structure of the company.|
3. Weighted Average Cost of Capital
This approach is widely used in corporate finance for decision-making while undertaking new projects.
RRR = (we x re) + ((wD x rD) x (1 – t))
wD – weight of debt
rD – cost of debt
t – corporate tax rate
we – weight of equity
re – cost of equity
Since WACC determines the company’s overall cost of financing, it can be regarded as a break-even return that computes the profitability of a project or an investment decision.