Required return: Meaning, Criticisms & Real-World Uses

What Is Required Return?

Required return is the minimum rate of return an investor expects or demands for taking on a particular investment. It represents the compensation necessary for the perceived risk of an asset or project. In the broader field of Investment Analysis and Financial Valuation, the required return serves as a critical benchmark. Investors use it to decide whether an asset is worth purchasing, while companies utilize it to evaluate the viability of new projects or acquisitions. The concept of required return ensures that the expected benefits from an investment adequately compensate for the potential downsides and the opportunity cost of foregoing other uses of capital.

History and Origin

The concept of a required rate of return evolved alongside modern financial theory, particularly with the development of quantitative models for valuing assets and managing portfolios. Early financial thought recognized that investors demand greater compensation for taking on more risk, but a precise framework for quantifying this relationship was lacking. A significant development in formalizing required return came with the introduction of the Capital Asset Pricing Model (CAPM) in the mid-1960s by economists like William F. Sharpe, John Lintner, and Jan Mossin. Building on Harry Markowitz's pioneering work in modern portfolio theory, CAPM provided a mathematical model to estimate the appropriate required return for an asset, given its systematic risk. This model posits that investors are compensated for systematic risk, which cannot be diversified away, but not for idiosyncratic risk. The CAPM's introduction marked a pivotal moment, offering a widely adopted formula that linked an asset's expected return to its sensitivity to market movements.²⁶, ²⁷, ²⁸

Key Takeaways

Required return is the minimum acceptable rate of return an investor demands for an investment, considering its risk.
It is a crucial input in investment decision-making and project evaluation for both individuals and corporations.
The required return helps determine if an asset is undervalued or overvalued, or if a project meets a company's hurdle rate.
It is directly influenced by the perceived risk of an investment and prevailing market conditions, including interest rates and inflation expectations.
Various models, such as the Capital Asset Pricing Model (CAPM), are used to estimate required return based on different risk factors.

Formula and Calculation

One of the most widely recognized formulas for calculating the required return, particularly for equity investments, is the Capital Asset Pricing Model (CAPM). The CAPM links the required return of a security to its systematic risk, measured by beta.

The formula is:

$R_i = R_f + \beta_i (R_m - R_f)$

Where:

(R_i) = Required return on equity (or asset i)
(R_f) = Risk-free rate (e.g., the yield on a U.S. Treasury bond)
(\beta_i) = Beta of the investment (a measure of its volatility relative to the overall market, representing its systematic risk)
(R_m) = Expected market return (the expected return of the overall market portfolio)
((R_m - R_f)) = Market risk premium (the additional return investors expect for investing in the market portfolio over the risk-free rate)²⁵

This formula helps to quantify the premium investors demand for taking on market-related risk beyond the basic compensation for time and inflation.

Interpreting the Required Return

The required return serves as a crucial threshold. For an investor, if an asset's expected return is higher than its required return, the asset is considered attractive or potentially undervalued. Conversely, if the expected return is lower than the required return, the asset may be deemed overvalued or simply not worth the risk.

In corporate finance, the required return often translates into a "hurdle rate" for new projects. Companies typically set a minimum required return for any new venture, often based on their weighted average cost of capital (WACC), which encompasses the required returns of both shareholders (equity) and lenders (debt). If a project's projected internal rate of return (IRR) or return on investment (ROI) falls below this hurdle rate, the project may be rejected, as it would not generate sufficient value for the company's capital providers.

Hypothetical Example

Imagine TechInnovate, a company considering a new research and development project. The company's financial analysts need to determine the required return for this project to assess its viability.

Determine the Risk-Free Rate: TechInnovate observes that 10-year U.S. Treasury bonds are yielding 3%. So, (R_f) = 3%.
Estimate Market Risk Premium: Historical data and market expectations suggest a market risk premium of 6%. So, ((R_m - R_f)) = 6%.
Calculate Project Beta: Based on the nature of the R&D project and comparable ventures, the analysts estimate the project's beta ((\beta_i)) to be 1.2, indicating it's slightly riskier than the overall market.

Using the CAPM formula:
(R_i = R_f + \beta_i (R_m - R_f))
(R_i = 3% + 1.2 \times (6%))
(R_i = 3% + 7.2%)
(R_i = 10.2%)

Therefore, the required return for this R&D project is 10.2%. If TechInnovate projects that this R&D initiative will generate an internal rate of return of, say, 12%, it would exceed the required return of 10.2% and might be considered a worthwhile capital budgeting investment.

Practical Applications

The concept of required return is fundamental across numerous areas of finance:

Corporate Finance: Companies use required return, often as part of their Weighted Average Cost of Capital (WACC), to evaluate potential projects, determine appropriate capital structures, and make strategic decisions about resource allocation. Understanding the required return for different sources of capital ensures that investments create value for the firm's stakeholders.²³, ²⁴
Investment Management: Portfolio managers and individual investors rely on required return to select securities. By comparing an asset's expected future cash flows and its current price, investors can determine if the inherent return meets or exceeds their required return given its risk profile. This often involves applying asset pricing models to assess fair valuation.
Valuation and Mergers & Acquisitions: In discounted cash flow (DCF) models, the required return (or a blended rate like WACC) is used as the discount rate to bring future cash flows back to their present value, enabling analysts to arrive at a fair value for a company or an acquisition target.²²
Regulatory Decisions and Policy: While not a direct regulatory tool, the underlying principles of required return inform discussions around fair rates of return for regulated industries (e.g., utilities) or in assessing the economic viability of public-private partnerships. Investors also form their own return expectations, as discussed in various financial communities.²⁰, ²¹

Limitations and Criticisms

While essential, the required return concept, particularly when estimated through models like CAPM, faces several limitations and criticisms:

Assumptions: CAPM, for instance, rests on several strong assumptions, such as rational investors, frictionless markets, and homogeneous expectations. In reality, markets are not perfectly efficient, investors may not always be rational, and information asymmetry exists.¹⁸, ¹⁹
Estimation Challenges: Accurately estimating inputs like the market risk premium and beta can be challenging. Beta calculations rely on historical data, which may not accurately predict future volatility. The market risk premium is also a subject of ongoing debate among academics and practitioners.¹⁷
Single-Factor Model: CAPM is a single-factor model, meaning it attributes all systematic risk to the market. Critics argue that other factors, such as company size, value (book-to-market ratio), momentum, or liquidity, also influence required returns. Multi-factor models, like the Fama-French Three-Factor Model, were developed to address these perceived shortcomings by including additional risk premiums.¹⁶
Market Imperfections: Real-world market imperfections like transaction costs, taxes, and borrowing/lending constraints can deviate from the theoretical assumptions of models used to derive required returns. The practical challenges in accurately determining and applying required returns continue to be a topic of discussion among financial professionals.¹⁵

Required Return vs. Discount Rate

The terms "required return" and "discount rate" are often used interchangeably in practice, but they have distinct meanings and applications.

The required return is the minimum rate of compensation an investor demands for a given level of risk. It is a forward-looking concept that represents the investor's expectation or hurdle for an investment to be considered worthwhile. For a company, it reflects the cost of obtaining capital from investors (both equity and debt providers).

The discount rate, on the other hand, is the rate used to calculate the present value of future cash flows in valuation methodologies, such as discounted cash flow (DCF) analysis. While the required return can serve as the discount rate in many contexts (e.g., if a project's cash flows are discounted at the firm's required return on capital, or an investor discounts an asset's expected cash flows at their personal required return), the term "discount rate" is broader. It might also refer to interest rates set by central banks for lending to commercial banks, or rates used for other financial calculations. However, in the context of investment valuation, the required return is often the key determinant of the discount rate.

FAQs

Why is required return important for investors?

Required return is crucial for investors because it helps them make informed decisions. It provides a benchmark against which to compare the potential gains of an asset. If the expected gains do not meet the required return, given the associated level of risk, an investor can choose to allocate their capital elsewhere.

How does risk affect the required return?

Risk and required return are directly related. Higher perceived risk in an investment typically leads investors to demand a higher required return as compensation for bearing that additional risk. Conversely, lower-risk investments usually have a lower required return. This relationship is a fundamental principle in finance, often visualized through concepts like the Security Market Line (SML).

Is required return the same as expected return?

No, required return is not the same as expected return. Required return is the minimum rate an investor demands to undertake an investment given its risk. Expected return is the anticipated or forecasted return an investor believes an investment will generate, based on various factors like historical performance, market conditions, and analyst forecasts. An investment is considered attractive when its expected return is greater than or equal to its required return.

Can required return be negative?

Theoretically, a nominal required return can be negative if the risk-free rate is negative and the risk premium is small enough to not offset it. However, in most practical applications in finance, especially for equity and corporate projects, the required return is a positive value, as investors generally expect to be compensated for the use of their capital and for any associated risk and inflation.¹ ² ³ ⁴, ⁵ ⁶, ⁷ ⁸ ⁹, ¹⁰ ¹¹ ¹², ¹³, ¹⁴