Required rate of return

Definition

The required rate of return is the minimum return an investor expects to receive from an investment, considering the risk associated with that investment. This rate is essential in determining the attractiveness of an investment, as it reflects the opportunity cost of capital and the investor's risk tolerance. Investors use this rate as a benchmark when evaluating potential investments and comparing them to other available options.

5 Must Know Facts For Your Next Test

1. The required rate of return can vary significantly based on the type of investment, market conditions, and individual investor preferences.
2. Investors often set their required rate of return based on benchmarks such as government bond yields or historical stock market returns.
3. A higher required rate of return generally indicates a higher perceived risk associated with the investment.
4. In common stock valuation models, the required rate of return is critical for calculating the present value of expected future cash flows.
5. Adjusting the required rate of return can significantly impact the valuation results and investment decisions, as it directly influences discounting cash flows.

Review Questions

• How does the required rate of return influence an investor's decision-making process regarding common stock investments?
  • The required rate of return acts as a benchmark for investors when assessing potential stock investments. By comparing the expected returns of a stock against this required rate, investors can determine if a stock is worth pursuing. If a stock's expected return exceeds the required rate, it may be considered an attractive investment; conversely, if it falls short, it may be deemed too risky or unappealing.
• In what ways do various factors such as market conditions and individual risk tolerance affect an investor's determination of their required rate of return?
  • Market conditions play a significant role in shaping the required rate of return as changes in interest rates, inflation expectations, and economic stability can influence investor perceptions of risk. Individual risk tolerance also impacts this determination; more risk-averse investors may set a lower required rate to account for their discomfort with uncertainty, while aggressive investors might seek higher returns to justify taking on more risk.
• Evaluate how different common stock valuation models incorporate the concept of required rate of return and how this affects overall investment strategy.
  • Different common stock valuation models, such as the Gordon Growth Model and the Discounted Cash Flow model, explicitly integrate the required rate of return to calculate the present value of future cash flows. By using this rate, investors can determine whether a stock is overvalued or undervalued relative to its current market price. Consequently, this affects overall investment strategy by guiding decisions on whether to buy, hold, or sell stocks based on their perceived value compared to the investor's required return threshold.

Related terms

Risk Premium: The additional return expected by an investor for taking on additional risk beyond that of a risk-free investment.

Discount Rate: The interest rate used to determine the present value of future cash flows, often equivalent to the required rate of return for a given investment.

Capital Asset Pricing Model (CAPM):

A model used to determine the expected return on an asset, factoring in its systematic risk as measured by beta.