What is the required rate of return - RRR?
The required rate of return is the minimum return that an investor would accept to own a company's shares, as compensation for a certain level of risk associated with holding the share. The legal support rate is also used in corporate finance to analyze the profitability of potential investment projects.
The required rate of return is also known as the obstacle rate, which like RRR, denotes the appropriate compensation needed for the current level of risk. More risky projects usually have higher obstacle or repeat request rates than less risky ones.
The formula and calculation of RRR
There are two methods of calculating the required rate of return. If an investor is considering buying equity shares in a dividend-paying company, the dividend-discount model is ideal. The dividend discount model is also known as the Gordon Growth Model.
Dividend Distribution Model - Discount to Equity Ratio for dividend stock is calculated by using the current share price, dividend payout per share, and projected earnings growth rate. The formula is as follows:
RRR = \ frac {\ text {expected dividend payment}} {\ text {participation rate}} + \ text {expected earnings growth rate} RRR =
Share price
Expected dividends
+ Projected profit growth rate
Calculate RRR using the profit discount model.
Take the expected dividend payment and divide it by the current share price.
Add the result to the expected profit growth rate.
How to calculate the required rate of return
Another way to calculate RRR is to use the Capital Asset Pricing Model (CAPM), which investors typically use for stocks that do not pay dividends.
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The CAPM model is used to calculate RRR the beta version of the original. Beta is the risk factor of holding. In other words, beta attempts to measure the risk of a stock or investment over time. Shares with a beta greater than 1 are considered riskier than the market as a whole (represented by the S&P 500), while stocks with a beta greater than 1 are considered less risky than the overall market.
The formula also uses the risk-free rate of return, which is usually the yield on short-term US Treasury notes. The final variable is the market rate of return, which is usually the annual return on the S&P 500. The RRR formula using the CAPM model is as follows:
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Calculate RRR using CAPM
Add your current risk-free rate of return to your security beta.
Take the market rate of return and subtract the risk-free rate of return.
Add results to achieve the desired rate of return.
Subtract the risk-free rate of return from the market rate of return.
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Take this score and hit it in the beta version of Safety.
Add the result to the current risk-free rate of return to determine the desired rate of return.
What does RRR say to you?
The required rate of return is a fundamental concept in valuing equity and corporate finance. It is a difficult metric to define due to the different investment objectives and risk tolerance of individual and corporate investors. Risk and return preferences, inflation expectations and a firm's capital structure all play a role in determining the required rate for the company. Each of these factors and others can have significant impacts on the intrinsic value of security.
For investors using the CAPM equation, the required rate of return for a share with a higher beta as compared to the market should be a higher interest rate. A higher high percentage ratio compared to other low beta investments is necessary to compensate investors for the additional level of risk associated with investing in higher beta stocks.
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In other words, RRR is calculated in part by adding the risk premium to the risk-free expected rate of return to calculate additional volatility and ex post risk.
For capital projects, RRR is useful in determining whether to pursue one project versus another. Program requirements (RRR) are required to advance the project although some projects may not meet the requirements of the program requirements but serve the interests of the company in the long run.
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