Required Rate of Return

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Definition: Required Rate of Return

Required rate of return is the return required by an individual on any investment/asset. It depends upon the cost of capital and other factors like risk aversion of the investor, volatility of the return etc. Only when the return on an investment equals or exceeds the required rate of return will the investor be willing to invest in the given asset.

Required rate of return is generally equal to the cost of capital, the reason being that if a project does not even guarantee the cost that is used to raise capital for it, it is not worthwhile to invest in it.

Required rate of return for a company/project can be calculated using the CAPM formula as follows:

Required rate of return = Cost of debt * Weight of Debt * (1- tax rate) + Cost of Equity * Weight of equity


Cost of equity = Risk Free Rate + Beta * Equity Risk Premium

For e.g. If the given risk free rate is 7%, the equity risk premium is 8%, beta of the company is 1.4, cost of debt is 10%, tax rate is 40%, total debt in the company being 50%


Cost of equity = 7 + 1.4 * 8 = 18.2%

Required rate of return = 0.5 * 10% * (1-40%) + 0.5 * 18.2% = 12.1%


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