Required return

Definition

Required return is the minimum return an investor expects to receive from an investment, taking into account its risk level. This return is essential for making informed investment decisions, as it helps determine whether an investment opportunity is worthwhile when compared to its risks and other available alternatives. It directly influences the cost of capital and the marginal cost of raising new funds for investments.

5 Must Know Facts For Your Next Test

1. Required return varies based on the level of risk associated with the investment, where higher risk typically demands a higher required return.
2. It can be calculated using various models, including the Capital Asset Pricing Model (CAPM), which factors in the risk-free rate, the investment's beta, and the expected market return.
3. Investors use required return as a benchmark to evaluate investment performance; if actual returns fall short, it may indicate a poor investment decision.
4. The required return is essential in capital budgeting as it helps firms decide which projects to undertake based on expected returns relative to costs.
5. Changes in market conditions or interest rates can influence the required return, impacting both individual investment decisions and overall corporate finance strategies.

Review Questions

• How does required return relate to an investor's perception of risk when evaluating potential investments?
  • Required return is directly influenced by an investor's perception of risk. Investors expect a higher required return for riskier investments to compensate for the uncertainty involved. This expectation helps them compare different investment opportunities and assess whether the potential reward justifies taking on the associated risks. By understanding required return, investors can make better decisions about where to allocate their resources.
• Discuss how the Capital Asset Pricing Model (CAPM) is used to calculate required return and its significance in corporate finance.
  • The Capital Asset Pricing Model (CAPM) calculates required return by incorporating the risk-free rate, the expected market return, and the investment's beta, which measures its volatility relative to the market. This model is significant in corporate finance as it provides a structured approach for determining the appropriate required return for various investments. By using CAPM, companies can effectively assess their cost of equity and make informed capital budgeting decisions that align with their overall financial strategy.
• Evaluate the impact of changes in economic conditions on required return and how this affects a firm's capital structure decisions.
  • Changes in economic conditions, such as fluctuations in interest rates or shifts in market sentiment, can significantly affect required return. For instance, during periods of economic uncertainty, investors may demand higher returns due to increased perceived risks, leading firms to reassess their capital structure decisions. If required returns rise, companies may find it more costly to raise funds through equity or debt financing, prompting them to consider alternative financing strategies or prioritize projects with higher expected returns to meet investor expectations.

Related terms

Cost of Capital: The rate of return that a company must earn on its investments to maintain its market value and satisfy its investors.

Risk Premium: The additional return an investor demands for taking on the higher risk associated with a particular investment compared to a risk-free asset.

Discount Rate: The interest rate used to discount future cash flows back to their present value, reflecting the opportunity cost of capital.