Docsity
Log inSign up
Docsity
Prepare for your exams
Prepare for your exams

Study with the several resources on Docsity

Earn points to download
Earn points to download

Earn points by helping other students or get them with a premium plan

Guidelines and tips
Guidelines and tips
Sell on Docsity
Sell on Docsity
Log inSign up

Prepare for your exams

Study with the several resources on Docsity

Find documents

Prepare for your exams with the study notes shared by other students like you on Docsity

Search Store documents

The best documents sold by students who completed their studies

Search through all study resources
Docsity AINEW

Summarize your documents, ask them questions, convert them into quizzes and concept maps

Explore questions

Clear up your doubts by reading the answers to questions asked by your fellow students

Earn points to download

Earn points by helping other students or get them with a premium plan

Share documents
download point icon20 Points

For each uploaded document

Answer questions
download point icon5 Points

For each given answer (max 1 per day)

All the ways to get free points
Get points immediately

Choose a premium plan with all the points you need

Study Opportunities

Choose your next study program

Get in touch with the best universities in the world. Search through thousands of universities and official partners

Community

Ask the community

Ask the community for help and clear up your study doubts

University Rankings

Discover the best universities in your country according to Docsity users

Free resources

Our save-the-student-ebooks!

Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors

From our blog

Exams and Study
Go to the blog

Calculating the Required Rate of Return (RRR) in Corporate Finance and Equity Valuation, Lecture notes of Corporate Finance

Edinboro University of Pennsylvania (EU)Corporate Finance

An in-depth explanation of the required rate of return (rrr), a crucial metric in corporate finance and equity valuation. The rrr determines the minimum profit needed for an investment or project, considering risk. Various uses of the rrr, including discounting cash flow models and the capital asset pricing model (capm). It also discusses the dividend discount model and the role of the rrr in corporate finance and equity investing.

Typology: Lecture notes

2021/2022

Uploaded on 09/12/2022

alexey
alexey 🇺🇸

4.7

(20)

326 documents

1 / 4

Toggle sidebar

This page cannot be seen from the preview

Don't miss anything!

bg1
How$to$calculate$Required$Rate$of$Return$(RRR)$
!
!
!
The!required!rate!of!return!(RRR)!is!a!component!in!many!of!the!metrics!used!in!
corporate!finance!and! equity!valuation.! The!required!rate!of!return!is!how!much!
profit!is!needed!in!order!to!go!forward!with!a!project!or!an!investment.!The!RRR!
can! be! used! to! help! investors! decide! whether! they! should! proceed! in! buying! a!
security.!However,!corporate! executives!and!financial!professionals!calculate!the!
RRR!for!projects!including! purchases!of!manufacturing! equipment!and!potential!
mergers!and!acquisitions.!
!
The!required! rate! of! return! goes! beyond!merely! identifying! the! return! from! an!
the! investment,! and! instead,! factors! in! risk! as! one! of! the! key! considerations! to!
determining! the! potential! return.! The! required! rate! of! return! also! sets! the!
minimum!return!an!investor!should!accept,!given!all!other!options!available!and!
the! capital! structure! of! the! company.! To! calculate! the! required! rate,! you! must!
look!at!factors!such!as!the!return!of!the!market!as!a!whole,!the!rate!you!could!get!
if!you!took!on!no!risk!(the!risk-free! rate!of!return),!and!the!volatility!of! the!stock!
or!the! overall! cost! of! funding! the! project.! Here! we! examine!this!metric!in!detail!
and! show! you! how! to! use! it! to! calculate! the! potential! returns! on! your!
investments.!(For!background! reading,!check!out!"FYI!on!ROI:!A!Guide!to!Return!
on!Investment.")!
!
Discounting$Models$
One! particularly! important! use! of! the! required! rate! of! return! is! in! discounting!
most!types!of!cash! flow!models! and!some!relative!value!techniques.! Discounting!
different! types! of! cash! flow! will! use! slightly! different! rates! with! the! same!
intention!–!finding!the!net!present!value.!
!
Common!uses!of!the!required!rate!of!return!include:!
!
• Calculating! the! present! value! of! dividend! income! for! the! purpose! of!
evaluating!stock!prices!
• Calculating!the!present!value!of!free!cash!flow!to!equity!
• Calculating!the!present!value!of!operating!free!cash!flow!
!
Equity,!debt,! and! corporate! expansion!decisions!are!made!by! placing! a! value!on!
the!periodic! cash!received!and! measuring!it!against! the!cash!paid.! The!goal!is!to!
receive!more!than!what!you!paid.!In!corporate!finance,!the!focus!is!on!the!cost!of!
funding!projects! compared! to!the!return.!In! equity! investing,! the!focus!is!on! the!
return!compared!to!the!risk!taken!on.!
!
Equity$and$Debt$
In!equity!investing,!the!required!rate!of!return!is!used!in!various!calculations.!For!
example,! the! dividend! discount! model! uses! the! RRR! to! discount! the! periodic!
payments!and!calculate!the!value!of!the!stock.!Finding!the!required!rate!of!return!
can!be!done!by!using!the!Capital'Asset'Pricing'Model!(CAPM).!
!
pf3
pf4

Partial preview of the text

Download Calculating the Required Rate of Return (RRR) in Corporate Finance and Equity Valuation and more Lecture notes Corporate Finance in PDF only on Docsity!

How to calculate Required Rate of Return (RRR) The required rate of return (RRR) is a component in many of the metrics used in corporate finance and equity valuation. The required rate of return is how much profit is needed in order to go forward with a project or an investment. The RRR can be used to help investors decide whether they should proceed in buying a security. However, corporate executives and financial professionals calculate the RRR for projects including purchases of manufacturing equipment and potential mergers and acquisitions. The required rate of return goes beyond merely identifying the return from an the investment, and instead, factors in risk as one of the key considerations to determining the potential return. The required rate of return also sets the minimum return an investor should accept, given all other options available and the capital structure of the company. To calculate the required rate, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (the risk-free rate of return), and the volatility of the stock or the overall cost of funding the project. Here we examine this metric in detail and show you how to use it to calculate the potential returns on your investments. (For background reading, check out "FYI on ROI: A Guide to Return on Investment.") Discounting Models One particularly important use of the required rate of return is in discounting most types of cash flow models and some relative value techniques. Discounting different types of cash flow will use slightly different rates with the same intention – finding the net present value. Common uses of the required rate of return include:

  • Calculating the present value of dividend income for the purpose of evaluating stock prices
  • Calculating the present value of free cash flow to equity
  • Calculating the present value of operating free cash flow Equity, debt, and corporate expansion decisions are made by placing a value on the periodic cash received and measuring it against the cash paid. The goal is to receive more than what you paid. In corporate finance, the focus is on the cost of funding projects compared to the return. In equity investing, the focus is on the return compared to the risk taken on. Equity and Debt In equity investing, the required rate of return is used in various calculations. For example, the dividend discount model uses the RRR to discount the periodic payments and calculate the value of the stock. Finding the required rate of return can be done by using the Capital Asset Pricing Model (CAPM).

The CAPM will require that you find certain inputs: a) The risk-free rate (RFR) b) The stock's beta c) The expected market return Start with an estimate of the risk-free rate. You could use the current yield to maturity of a 10 year T-bill – let's say it's 4%. Next, take the expected market risk premium for the stock which can have a wide range of estimates. For example, it could range between 3% to 9%, based on factors such as business risk, liquidity risk, and financial risk. Or, you can derive it from historical yearly market returns. For illustrative purposes, we'll use 6%, rather than any of the extreme values. Often, the market return will be estimated by a brokerage firm, and you can subtract the risk-free rate. Lastly, you can use the beta βof the stock. To calculate beta manually, use the following regression model: Return of Stock = α + βstock * Rmarket Where:

  • βstock is the beta coefficient for the stock, meaning it is the covariance between the stock and the market divided by the variance of the market. We will assume the beta is 1.25.
  • Rmarket is the return expected from the market. For example, the return of the S&P 500 can be used for all stocks trading on it – and even somestocks not on the index, but related to businesses that are.
  • α shown as α is a constant that measures excess return for given level of risk Now we put together these three numbers using the Capital Asset Pricing Model: E(R) = RFR + βstock (Rmarket – RFR) E(R) = 0.04 + 1.25 (6) E(R) = 11.5% Where: E(R) = the required rate of return, or expected return RFR = the risk-free rate βstock = beta of the stock Rmarket = return of the market as a whole (Rmarket – RFR) = the market risk premium, or the return above the risk-free rate to accommodate additional unsystematic risk

Where: WACC = weighted average cost of capital (firm-wide required rate of return) Wd = weight of debt kd = cost of debt financing t = tax rate Wps = weight of preferred shares kps = cost of preferred shares Wce = weight of common equity kce = cost of common equity When dealing with internal corporate decisions to expand or take on new projects, the required rate of return is used as a minimum acceptable return benchmark – given the cost and returns of other available investment opportunities. For more on this topic, please read "Evaluating a Company's Capital Structure." The Bottom Line The required rate of return is a difficult metric to pinpoint due to the various estimates and preferences from one decision maker to the next. The risk-return preferences, inflation expectations, and the firm's capital structure all play a role in determining the required rate. Each one of these and other factors can have major effects on an asset's intrinsic value. As with many things, practice makes perfect. As you refine your preferences and dial in estimates, your investment decisions become dramatically more predictable.