Required rate of return

Definition

The required rate of return is the minimum return an investor expects to earn from an investment, factoring in the risk associated with that investment. It serves as a benchmark for evaluating potential investments and is crucial in the context of valuing stocks using models that incorporate dividends and growth rates. Investors use this rate to assess whether an investment aligns with their risk tolerance and investment goals.

5 Must Know Facts For Your Next Test

1. The required rate of return varies depending on the risk profile of the investment; higher risks generally demand higher returns.
2. Investors calculate the required rate of return by adding a risk-free rate to a premium that compensates for the investment's specific risks.
3. In the Dividend Discount Model, the required rate of return is essential for calculating the present value of future dividend payments.
4. If the expected return on an investment falls below its required rate of return, investors may choose to forego that investment in favor of others with more favorable returns.
5. Changes in interest rates can significantly influence the required rate of return, as they affect both the risk-free rate and overall market conditions.

Review Questions

• How does the required rate of return influence investment decisions in relation to dividend-paying stocks?
  • The required rate of return plays a critical role in investment decisions for dividend-paying stocks by establishing a benchmark that expected returns must meet or exceed. Investors evaluate if the expected dividends, discounted at this required rate, justify the stock's price. If the calculated intrinsic value based on dividends does not align with the market price when considering this required rate, investors might decide against purchasing or holding that stock.
• Discuss how changes in market conditions affect the calculation of the required rate of return and subsequently impact stock valuations.
  • Changes in market conditions can lead to fluctuations in both the risk-free rate and market risk premiums, which are key components in calculating the required rate of return. For instance, during economic downturns, perceived risks rise, prompting investors to demand a higher return. This adjustment impacts stock valuations by raising the discount rate used in models like the Dividend Discount Model, often resulting in lower present values for expected future dividends and potentially decreasing stock prices.
• Evaluate how an investor could use the Capital Asset Pricing Model (CAPM) to derive their required rate of return and make informed investment choices.
  • An investor can utilize CAPM to derive their required rate of return by assessing an asset's systematic risk through its beta coefficient, which measures sensitivity to market movements. By plugging this beta into the CAPM formula alongside the risk-free rate and market risk premium, the investor can quantify what return they should expect from taking on that specific risk. This informed expectation aids in comparing various investments and deciding where to allocate capital effectively, ensuring alignment with personal risk tolerance and financial goals.

Related terms

Dividend Discount Model: A valuation method that estimates the price of a stock based on the present value of its expected future dividends.

Cost of Equity: The return a company is expected to generate for its equity investors, often equated to the required rate of return for equity investments.

Capital Asset Pricing Model (CAPM): A model used to determine the expected return on an asset based on its systematic risk as compared to that of the market.