Required Rate of Return

Definition

The required rate of return is the minimum rate of return an investor or company expects to receive on an investment, given the risk associated with that investment. It is a critical factor in evaluating capital investment decisions and assessing the performance of operating segments or projects.

5 Must Know Facts For Your Next Test

1. The required rate of return is the minimum acceptable rate of return that an investor or company expects to earn on an investment, given the risk associated with that investment.
2. The required rate of return is used as the discount rate in discounted cash flow (DCF) models, such as net present value (NPV) and internal rate of return (IRR), to evaluate the viability of capital investment decisions.
3. The required rate of return is often based on the weighted average cost of capital (WACC), which represents the blended cost of a company's debt and equity financing.
4. A higher required rate of return indicates a higher level of risk associated with the investment, and vice versa.
5. The required rate of return is a crucial factor in evaluating the performance of operating segments or projects using metrics such as return on investment (ROI), residual income, and economic value added (EVA).

Review Questions

• Explain how the required rate of return is used in discounted cash flow models to make capital investment decisions.
  • The required rate of return is used as the discount rate in discounted cash flow (DCF) models, such as net present value (NPV) and internal rate of return (IRR), to evaluate the viability of capital investment decisions. The required rate of return represents the minimum acceptable rate of return that an investor or company expects to earn on an investment, given the risk associated with that investment. By discounting the projected future cash flows of a capital investment using the required rate of return, the NPV model can determine whether the investment is expected to generate a return that meets or exceeds the required rate of return, making it a viable investment opportunity.
• Describe how the required rate of return is used to evaluate the performance of an operating segment or a project using return on investment (ROI), residual income, and economic value added (EVA).
  • The required rate of return is a critical factor in evaluating the performance of an operating segment or a project using various metrics, such as return on investment (ROI), residual income, and economic value added (EVA). The required rate of return represents the minimum acceptable rate of return that the company expects to earn on the investment, given the risk associated with it. By comparing the actual returns generated by the operating segment or project to the required rate of return, these performance metrics can assess whether the investment is generating a return that meets or exceeds the company's expectations. For example, residual income measures the amount of income generated by an investment after deducting a charge for the capital employed, using the required rate of return as the charge. Similarly, economic value added (EVA) compares the actual returns generated by an investment to the required rate of return, providing a measure of the value created or destroyed by the investment.
• Analyze how the required rate of return is influenced by factors such as the company's capital structure, risk profile, and market conditions, and explain the implications of changes in the required rate of return on capital investment decisions and performance evaluation.
  • The required rate of return is influenced by a variety of factors, including the company's capital structure, risk profile, and market conditions. The company's capital structure, represented by its weighted average cost of capital (WACC), is a key determinant of the required rate of return, as it reflects the blended cost of the company's debt and equity financing. A higher WACC, and consequently a higher required rate of return, indicates a higher level of risk associated with the investment. Additionally, the company's risk profile, as measured by factors such as industry competition, regulatory environment, and economic conditions, can also impact the required rate of return. Changes in market conditions, such as interest rate fluctuations or shifts in investor sentiment, can also affect the required rate of return. Variations in the required rate of return have important implications for capital investment decisions and performance evaluation. A higher required rate of return may make some investment opportunities less viable, as the projected cash flows may not meet the higher return threshold. Conversely, a lower required rate of return may make more investments attractive and lead to a reevaluation of the performance of existing operating segments or projects. Understanding the factors that influence the required rate of return and its impact on decision-making and performance evaluation is crucial for effective financial management.

Related terms

Discount Rate:

The rate used to calculate the present value of future cash flows, which is typically equal to the required rate of return.

Net Present Value (NPV):

The difference between the present value of an investment's expected cash inflows and the present value of its expected cash outflows, using the required rate of return as the discount rate.

Weighted Average Cost of Capital (WACC):

The average rate of return a company must pay to all its security holders to finance its assets, which is often used as the required rate of return for capital investment decisions.