What is the required rate of return?

The required rate of return is the minimum return that a company or an investor expects to achieve if it invests in a project or business. The required rate of return is influenced by:

• Risk of the investment. A company or investor may insist on a higher required rate of return for what is perceived to be a risky investment, or a lower return on a correspondingly lower-risk investment.
• Liquidity of the investment. If an investment cannot return funds for a number of years, this effectively increases the risk of the investment, which in turn increases the required rate of return.
• Inflation. The required rate of return must be layered on top of the expected inflation rate. Thus, a high expected inflation rate will drastically increase the required rate of return.

The required rate of return is useful as a benchmark, below which possible projects and investments are discarded. Thus, it can be an excellent tool for sorting through a variety of investment options.

The required rate of return is not the same as the cost of capital of a business. The cost of capital is the cost that a business incurs in exchange for the use of the debt, preferred stock, and common stock given to it by lenders and investors. The cost of capital represents the lowest rate of return at which a business should invest funds, since any return below that level would represent a negative return on its debt and equity. The required rate of return should never be lower than the cost of capital, and it could be substantially higher.

The level of the required rate of return, if too high, effectively drives investment behavior into riskier investments. Thus, a 3% rate of return would allow one to invest in a variety of low-risk opportunities, whereas a 15% rate of return would likely eliminate the lower-risk options, leaving an investor with a much smaller number of higher-risk alternative investment opportunities.

Related Topics

The hurdle rate 
Net present value 
The payback period 
What is the accounting rate of return? 
What is the simple rate of return?