What is Required Rate of Return (RRR)?

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The Time Value for Money is usually expressed by an interest rate that remains positive even without any risk. This rate is therefore called risk free rate. An individual or a company may agree to receive a payment if the risk-free rate is applied to his investment.

For example, suppose an investor has invested INR 100 in a project and the risk-free rate is 5%. Now if he is offered INR 105 after one year, he may choose to receive the money later as he might consider the value of money received after one year equal to the money without a risk-free rate now.

NoteThe RRR principle is based on the concept of the Time Value of Money.RRR lets investors calculate the correct future value of an investment.

In reality, all investors are exposed to some form of return on their investment and they need to compensate this with a risk premium. The risk premium compensates the investors from both time and risk and must be considered as unavoidable in the case of all types of investments.

NoteInvestors include a risk premium for uncertainties of the future and other factors.

The required rate of return is thereby given by,

RRR = Risk Free Rate + Risk Premium

In the equation, Risk-Free Rate compensates for the time of investment, and Risk Premium compensates for the risk involved in the investment.That is why the RRR is called the opportunity cost of investment because an investor could invest money in assets and equities of equivalent risk.

Like individuals, companies also calculate the RRR for their investments.It is used to compare the assets or securities of the same value but of different risks to the firm. The interest rates cover the time value of money regardless of an individual's preference and desirability.

Example of Investment Decision based on RRR

How does RRR help an individual or a firm decision to go for investment or letting it forego? Let us understand this with an example.

Let us consider an individual getting an interest rate of 20%. If she is offered INR 131 after one year, should she accept the offer? Yes. She should actually accept any offer that returns her more than 20% of her investment or INR 120.

NoteAn investor should accept a payment that offers more than the required rate of return.

Published on 13-Aug-2021 14:16:37