Required Return

Definition

Required return is the minimum return an investor expects to achieve from an investment, compensating for its risk. This concept is crucial as it serves as a benchmark for evaluating investment opportunities, helping to determine whether a project or investment aligns with an investor's risk tolerance and financial goals. Understanding required return aids in calculating the cost of capital, which is essential for making informed financial decisions.

5 Must Know Facts For Your Next Test

1. The required return can be influenced by various factors including market conditions, interest rates, and the specific risk profile of the investment.
2. Investors typically use models like the Capital Asset Pricing Model (CAPM) to calculate the required return by considering the risk-free rate and the investment's beta.
3. A higher required return indicates that investors perceive greater risk associated with an investment, while a lower required return suggests a safer investment.
4. Understanding required return is essential for firms to set their cost of capital, impacting decisions related to financing and project evaluation.
5. In practice, failing to meet the required return can lead investors to withdraw their support, negatively impacting a company's ability to finance future projects.

Review Questions

• How does the required return serve as a benchmark for evaluating investment opportunities?
  • The required return acts as a benchmark by establishing the minimum expected return that investors need to justify taking on a particular investment's risks. If an investment's anticipated returns fall below this threshold, it may not be considered worthwhile. This helps investors filter through various opportunities and focus on those that align with their financial objectives and risk tolerance.
• Discuss how factors such as market conditions and interest rates can influence the required return.
  • Market conditions and interest rates significantly impact the required return by altering investors' perceptions of risk. For example, during periods of economic uncertainty or high volatility, investors may demand a higher required return due to increased perceived risks associated with investments. Conversely, when interest rates are low, the overall cost of borrowing decreases, potentially leading to a lower required return as investments appear less risky.
• Evaluate the implications of not achieving the required return on a company's financial strategy and investor relations.
  • Not achieving the required return can have serious implications for a company's financial strategy and investor relations. It may indicate that a firm is underperforming relative to market expectations, which could lead to decreased investor confidence and support. This situation might force the company to reassess its projects or strategies to ensure better alignment with investor expectations or even seek alternative financing methods if investors withdraw support due to unmet returns.

Related terms

Cost of Equity: The return that equity investors require on their investment in a firm, reflecting the compensation for the risk they undertake.

Weighted Average Cost of Capital (WACC): A calculation of a firm's cost of capital in which each category of capital is proportionately weighted, used to evaluate investment opportunities.

Risk Premium: The additional return above the risk-free rate that investors demand for taking on additional risk associated with a specific investment.