Required Rate of Return (CAPM) Calculator
Required Rate of Return (RRR)
Understanding the Required Rate of Return (RRR)
The Required Rate of Return (RRR) is the minimum percentage of profit an investor demands for choosing to invest in a particular asset or project. In financial theory, specifically using the Capital Asset Pricing Model (CAPM), the RRR accounts for both the time value of money and the specific risk associated with the investment.
Components of the Formula
- Risk-Free Rate: This is the theoretical return on an investment with zero risk, usually represented by the yield on long-term government bonds (like the 10-year US Treasury).
- Beta (β): This measures the sensitivity of the asset's returns compared to the overall market. A beta of 1.0 means the asset moves with the market; higher than 1.0 means it is more volatile.
- Equity Risk Premium: This is the term (Market Return – Risk-Free Rate), representing the extra return required for taking on the risk of the stock market over a risk-free asset.
Practical Example
Suppose you are looking at a tech stock with a Beta of 1.5. If the current 10-year Treasury yield (Risk-Free Rate) is 4% and the historical average Market Return is 10%, your calculation would be:
RRR = 4% + 1.5 × (10% – 4%) = 13%
In this scenario, you should only invest in this stock if you believe it will return at least 13% annually.
Why RRR Matters
For individual investors, the RRR helps in deciding whether a stock is "worth the risk." For corporate finance managers, the RRR (often referred to as the Hurdle Rate) is used to determine if a new project or acquisition will add value to the company. If the expected return is lower than the RRR, the investment should generally be avoided.