Required Rate of Return

Investors have choices. They can put money in a safe government bond or in riskier assets such as shares. The required rate of return reflects the return needed to compensate for the time value of money and for the risk of the specific investment.

It is often built from a risk-free rate plus a risk premium. For example, if government bonds yield 4% and an investor believes a particular share needs an extra 5% to justify its risk, their required rate of return is 9%.

For companies, the required rate of return of shareholders is the cost of equity, often estimated using the Capital Asset Pricing Model. For whole businesses or projects, it is often the weighted average cost of capital.

The required rate of return is used as the discount rate in valuation models, such as the dividend discount model and discounted cash flow analysis. A higher required return leads to a lower present value. If an investment's expected return is below the investor's required return, the investor should not invest, because better risk-adjusted options are available elsewhere.