Required Rate of Return
Required rate of return is the minimum return in percentage that an investor must receive due to time value of money and as compensation for investment risks.
There are multiple models to work out required rate of return on equity, preferred stock, debt and other investments.
The most basic framework is to estimate required rate of return based on the risk-free rate and add inflation premium, default premium, liquidity premium and maturity premium, whichever is applicable.
The formula for the general required rate of return can be written as:
Required Return = rf + IRP + DRP + LRP + MRP
rf is the real risk-free rate is the rate of return on Treasury inflation-protected securities.
IRP stands for inflation risk premium, the compensation for inflation risk;
DRP stands for default risk premium, the compensation for risk of investment loss due to default;
LRP stands for liquidity risk premium, the compensation for illiquidity and lack of marketability and
MRP stands for maturity risk premium, the compensation for higher interest rate risk and reinvestment risk that results from longer maturities.
Required Return on Equity (i.e. Common Stock)
The required return on equity is also called the cost of equity. There are three common models to estimate required return on common stock: the capital asset pricing model, the dividend discount model and the bond yield plus risk premium approach.
Capital Asset Pricing Model (CAPM) Formula
The capital asset pricing model estimates required rate of return using the following formula:
Required Return on Equity (CAPM)
= Risk Free Rate (rf) + Equity Risk Premium
= Risk Free Rate (rf) + Beta × Market Risk Premium
= Risk Free Rate (rf) + Beta × (Market Return (rm) − Risk Free Rate (rf))
Where rf is the nominal risk-free rate, beta coefficient is a measure of systematic risk and rm is the return on the broad market index such as S&P 500. Equity risk premium equals beta multiplied by market risk premium and market risk premium equals the difference between rm and rf.
Dividend Discount Model (DDM) Formula
The dividend discount model (DDM) estimates required return on equity using the following formula:
|Required Return on Equity (DDM) =||D0 × (1 + g)||+ g|
Where D0 is the current annual dividend per share, P0 is the current price of the stock and g is the growth rate of dividends. The growth rate equals the product of retention ratio and return on equity (ROE).
g = Retention Ratio × ROE
Bond Yield plus Risk Premium Approach Formula
The bond yield plus risk premium approach adds a certain equity risk premium (based on historical analysis) to the yield on a company’s publicly-traded bonds.
Required Return on Preferred Stock
Required return on preferred stock is also called cost of preferred stock and it equals the ratio of preferred dividends per share (D) to the current price of the preferred stock (P0):
|Required Return on Preferred Stock =||D|
Required Return on Debt
Required return on debt (also called cost of debt) can be estimated by calculating the yield to maturity of the bond or by using the bond-rating approach.
|Bond Price = c × F ×||1 − (1 + r)-t||+||F|
|r||(1 + r)t|
Where, c is the periodic coupon rate which equals annual coupon rate divided by number of coupon payments per year, F is the face value i.e. principal amount, t is total number of coupon payments till maturity, and r is the periodic yield to maturity. Annual yield to maturity equals periodic yield to maturity multiplied by coupon payments per year.
Where the debt is not publicly traded, the required return on debt can be inferred from the yield to maturity of other marketable bonds which carry the same bond rating as the bond under consideration.
The build-up approach can also be used to estimate required return on debt. It involves adding inflation, default, liquidity and maturity premia to the real risk free rate.