In 2024, the S&P 500 delivered a total return of 23.31%, slightly below the previous year’s 26% gain. Despite this strong performance, projections for 2025 suggest more moderate returns. These projections underscore the significance of the required rate of return in investment decisions.
So, when projected returns are compared against a required rate of return, the gap reveals more than just performance potential.
If you’re a first-time investor who wants to better understand RRR, this article will explain its definition, formula, examples, and importance.
It will also discuss the factors affecting RRR to help you evaluate investments more precisely and avoid committing to underperforming assets.
What Is the Meaning of Required Rate of Return?
The required rate of return (RRR) refers to the minimum acceptable return an investor expects before committing capital to an asset.
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How Does the Required Rate of Return Work?
The required rate of return sets the threshold for deciding if the potential gain compensates for the level of risk involved. This threshold is also called the risk-adjusted return.
This reference point is crucial when comparing short-term investments, like treasury bills or money market instruments, with long-term investments such as stocks, bonds, hybrid annuities, or real estate.
For instance, if a stock, bond, or real estate deal projects returns above this rate, it passes the initial test. If it falls short, it’s usually dismissed early in the evaluation.
How to Calculate Required Rate of Return
CAPM Formula for Required Rate of Return
You can calculate the required rate of return using the capital asset pricing model (CAPM), which adjusts for market risk. The formula is:
Required Rate = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)
Suppose you take a corporate bond expected to return 7% annually. The risk-free rate is 3%, and you apply a 3% premium to account for credit risk and inflation.
As a result, the required rate of return would be:
Required Rate = 3% + 3% = 6%
Since the bond offers 7%, it exceeds the 6% threshold. This difference helps support the decision, assuming the bond’s maturity and rating align with your investment strategy.
DDM Formula for Required Rate of Return
The Dividend Discount Model (DDM) estimates the required rate of return based on the expected dividends and the stock’s current price.
This model works best for companies that pay consistent dividends. The formula is:
Stock Value = D₁ ÷ (k − g)
Where:
D₁ = Expected annual dividend per share
k = Investor’s discount rate, or required rate of return
g = Growth rate of dividend
Let’s say a stock pays an annual dividend of $2, trades at $40, and dividends are expected to grow by 4% per year.
Rearranging the formula to solve for k:
k = (D₁ ÷ Stock Value) + g
So:
k = ($2.50 ÷ $50) + 0.04 = 0.05 + 0.04 = 0.09 or 9%
If your minimum return target is below 9%, the stock clears your threshold and may warrant further review.
WACC Formula for Required Rate of Return
The weighted average cost of capital (WACC) calculates a company’s average cost of financing from both equity and debt.
The formula is:
WACC = Wd × [kd × (1 − t)] + Wps × kps + Wce × kce
Where:
Wd = proportion of debt
kd = cost of debt
t = tax rate
Wps = proportion of preferred stock
kps = cost of preferred stock
Wce = proportion of common equity
kce = cost of common equity
Let’s say a company is financed with 50% debt, 10% preferred shares, and 40% common equity.
Meanwhile, the cost of debt is 6%, the tax rate is 25%, the cost of preferred shares is 7%, and the cost of common equity is 10%.
You’d calculate:
WACC = 0.50 × [0.06 × (1 − 0.25)] + 0.10 × 0.07 + 0.40 × 0.10
= 0.50 × 0.045 + 0.007 + 0.04
= 0.0695 or 6.95%
This 6.95% becomes the required return the company must meet for new projects to be considered financially viable.
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How Does the Required Rate of Return Apply in Investing?
The required rate of return acts as a baseline in the following ways:
Investment Allocation
Investment allocation means dividing your capital across different asset types based on the expected return from each. The required rate of return acts as a filter during this process.
It helps you decide which assets earn a place in your portfolio.
For example, if your target return is 7% and bonds only yield 4%, you might shift more capital toward stocks that show stronger return potential.
Asset Pricing
Asset pricing involves assessing an investment’s worth based on its expected return. If the return falls below your required rate, the asset often ends up being overpriced relative to your expectations.
Say a stock is projected to return 7%, but your required rate is 10%. In that case, you’d likely pass, since the return doesn’t justify the price.
Corporate Investments
Companies apply the required rate of return when reviewing new projects or capital expenditures. A proposal must exceed this rate to move forward.
If you manage budgeting for a business and a new warehouse expansion only forecasts a 5% return while your company’s benchmark is 9%, you’d probably decline the project.
Portfolio Construction
Portfolio construction involves choosing assets that match your return goals and risk tolerance. In this aspect, the required rate of return helps screen out underperformers.
If your target return is 8% and too many holdings project below that mark, you’d restructure the assets to better align with your benchmark.
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Why Is Required Rate of Return Important?
RRR is significant in investing for the following reasons:
It Provides an Investment Benchmark
Since RRR is a baseline for evaluating investments, it gives you a number to measure against when reviewing potential assets.
Say your benchmark is 10%, and a mutual fund projects just 6%. You’d likely skip it and focus on alternatives with higher return potential.
Reflects Your Required Compensation for Taking Risks
This rate adjusts based on your willingness to accept uncertainty. Higher risk demands a higher return to make the investment worthwhile.
For example, if you’re considering cryptocurrency, you might set your required return at 15% before you allocate funds.
Helps You Determine if You Can Achieve Your Desired Outcomes
RRR ensures your goals are grounded in numbers. It shows if your current or future investments are on track to meet those targets.
If you aim for a 12% return to reach your retirement timeline and your current assets only project 8%, you might reallocate into higher-growth options.
Used In Valuing Assets
RRR feeds directly into valuation models like discounted cash flow, which affects future income. A higher required rate results in a lower present value.
So, if you’re comparing two startups with similar risk profiles, you’d favor the one offering more substantial cash flow relative to your required return.
Helps Evaluate Your Portfolio’s Performance
Your required rate of return is a tool for measuring actual outcomes. It lets you see whether your portfolio is on track or lagging.
For instance, if you fall below your 9% benchmark, you might shift out of slower-growth bonds and into assets with higher expected yields.
Aids In Justifying Expected Returns
RRR also helps make your return targets defensible. You can explain projections by showing how they align with calculated risk levels.
If a client expects a 10% return, you can point to their required rate to confirm whether that’s realistic or needs adjustments.
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What Are the Factors Influencing the Required Rate of Return?
These factors explain why return expectations differ across investors, assets, and timeframes:
Market Conditions
Shifts in the economy, such as rising interest rates, tariffs, or signs of recession, directly impact how investors assess risk. During periods of instability, the required rate of return tends to rise to offset the increased uncertainty.
For example, if markets are volatile and tariffs are tightening margins, you might raise your RRR from 8% to 11% before investing any capital.
Risk Tolerance
Your personal tolerance for loss or fluctuation affects how much return you expect in exchange for taking on risk. A higher risk tolerance usually pushes your RRR up, since you’re open to more volatile assets.
Suppose you prefer more stability. You might require at least 6% from investments that carry lower variance and consistent income.
Risk-Free Rate
The risk-free rate, generally based on the U.S. Treasury bonds, is the foundation of the required return. As this baseline increases, so does the expected return from any investment with added risk.
Let’s say the Treasuries yield 5%. You might need 9% from corporate bonds to justify shifting money away from a safer option.
Risk Premium
The risk premium compensates for uncertainty beyond the risk-free rate. The greater the risk, the higher the return you would require to justify it.
If you compare a startup to a large-cap stock, you might expect 12% from the startup and settle for 6% from the more established company.
Inflation Expectations
Expected inflation lowers the real value of future returns. To offset that erosion, your required return has to rise.
Perhaps a forecast points to 4% inflation. You’d likely increase your RRR to at least 9% just to maintain the same purchasing power.
Interest Rates
Interest rates influence how appealing safer alternatives become. When they go up, other assets must offer more to compete.
For instance, if certificates of deposit start paying 6%, you might set your RRR at 9% or higher before allocating funds to stocks.
Capital Structures
A company’s capital structure, particularly how much debt it carries, adds another layer of risk. This means that more debt increases the chance of default, which pushes your RRR higher.
If you’re evaluating a firm that’s 70% debt-financed, you’d likely require more return than from a peer with a 30% debt load.
Time Horizon
The length of your investment period also changes how you approach return expectations. Longer timelines bring more uncertainties, which usually call for higher returns.
Maybe you’re committing funds for 20 years instead of five. As a result, you might raise your RRR from 7% to 10% to cover that extended risk.
Beta
Beta reflects how much an investment moves relative to the market. Higher beta means more volatility, which requires a higher return to make the risk acceptable.
Take a tech stock that has a beta of 1.5, for example. You might set your RRR at 13% instead of the 9% you’d apply to a more stable company.
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Conclusion
Setting a required rate of return gives structure to your investment decisions. It helps you weigh risk, compare options, and stay aligned with your financial objectives.
Whether you’re building a portfolio or valuing a project, it keeps your decisions grounded in measurable outcomes.
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