What is Required Rate of Return (RRR)?

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The required rate of return (RRR) is basically the lowest return an investor is willing to accept for holding a company’s stock, reflecting the risk involved. It’s also a key concept in corporate finance for evaluating how profitable potential investment projects might be.

You might hear RRR referred to as the hurdle rate, which signifies the necessary compensation for the level of risk involved. Generally, riskier projects come with higher hurdle rates or RRRs compared to safer ones.

Calculation of Required Rate of Return (RRR)

If someone is thinking about investing in a company that offers dividends, the dividend discount model is a great choice. A well-known version of this model is the Gordon Growth Model. This model helps determine the required rate of return (RRR) for a dividend-paying stock by using the current stock price, the dividend amount per share, and the expected growth rate of those dividends. Here’s the formula:

RRR =  (Expected dividend payment / Share Price) + Forecasted dividend growth rate

The formula takes into account the risk-free rate of return, usually based on the yield from short-term U.S. Treasury securities. Another key factor is the market rate of return, which is generally the yearly return from the S&P 500 index. Here’s how you can calculate the RRR using the CAPM model:

RRR =  Risk-free rate of return + Beta X (Market rate of return - Risk-free rate of return)

Conclusion

The required rate of return (RRR) helps investors decide if they should go for new projects, invest in something, or buy shares in a company. It reflects the risks tied to an investment and can differ based on how much risk each investor is willing to take. The RRR serves as a baseline for what investors consider a minimum acceptable return when looking at the costs and potential returns of similar investment options.

There are various models out there to figure out the required rate of return for a project or investment, but keep in mind that these calculations usually don’t take into account inflation expectations or how easily an investment can be turned into cash.