The Required Rate of Return (RRR) is the minimum annual profit an investment must generate to be considered worthwhile. It represents the return an investor expects to receive for taking on a particular level of risk. If an investment's expected return is lower than the RRR, an investor would typically not proceed with it.
Key Components:
Risk-Free Rate: This is the theoretical rate of return of an investment with zero risk, typically represented by the yield on government bonds (like U.S. Treasury bonds) of a comparable maturity. It compensates investors for the time value of money.
Equity Risk Premium (ERP): This is the excess return that investing in the stock market provides over a risk-free rate. It's the additional compensation investors demand for taking on the higher risk of equity investments compared to risk-free assets.
Beta (β): Beta measures a stock's volatility or systematic risk relative to the overall market. A beta of 1 means the stock's price tends to move with the market. A beta greater than 1 indicates higher volatility than the market, and a beta less than 1 indicates lower volatility.
How it's Calculated:
The most common model for calculating the Required Rate of Return is the Capital Asset Pricing Model (CAPM).