Required rate of return

Definition

Required rate of return is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. It accounts for the risk-free rate plus a risk premium.

5 Must Know Facts For Your Next Test

1. It represents the opportunity cost of investing capital elsewhere.
2. Often used in calculating the present value of future cash flows in perpetuities.
3. Higher risk investments typically have higher required rates of return.
4. Incorporates both the risk-free rate and a premium for investment risks.
5. Can be used to assess whether an investment meets financial goals.

Review Questions

• What components make up the required rate of return?
• How does the required rate of return influence the valuation of perpetuities?
• Why might an investor demand a higher required rate of return for certain projects?

Related terms

Risk-Free Rate: The theoretical return on an investment with zero risk, often represented by government bonds.

Present Value: The current value of a future sum of money or stream of cash flows given a specified rate of return.

Perpetuity: A type of annuity that receives an infinite amount of periodic payments.