The required rate of return – A term used in capital discretionary budgeting, it is the rate of return required for one long-term investment opportunity out of many. An investment opportunity is accepted when the expected rate of return is greater than the required rate of return.
The marginal ratio allows companies to make important decisions about continuing work on the project. It determines the appropriate compensation for the current level of risk, and the marginal rate often rises with the increase in the risk of the project. In order to determine the marginal rate, several things must be taken into account, including the risks associated with the project, the costs of capital, and the returns on other potential projects or investments.
The risk premium for a potential investment is determined in order to indicate the expected magnitude of the related risks; the higher the risk, the greater the risk premium, because it is considered that the higher the risk of losing money in the investment means that the return on the investment will be greater.
Using the required rate of return helps determine the possibilities of an investment and reduce any bias that arises from favoring a project. Determining the appropriate risk factor enables the investor to use the marginal rate to prove the financial merit of the project, regardless of the intrinsic value assigned to it.
How to calculate the required rate of return ?
This rate is calculated by summing up the two main components of the capital budget:
- The company’s cost of capital, which is called the weighted average cost of capital,”
- The risk premium depends entirely on the severity of the project itself.
Thus, the formula for calculating the required return used in the capital budget is as follows:
WACC + Risk Premium = Required Rate of Return
For example, a manufacturing company wants to purchase a machine to manufacture its primary product and estimates that this machine will increase sales and thus increase its return on investment by 13%. The company’s weighted average cost of capital is 6%, and the risk of not selling an additional amount of the primary product is low, so the risk premium for it has been set at a low rate of 2%.
As a result, the marginal rate equals the weighted average cost of capital (6% + 2% risk premium) = 8%.
Since the marginal rate is 8% and the expected return on investment is greater than the marginal rate, the purchase of a new manufacturing machine is a good investment.
Determinants of the required rate of return
- The investor can be biased toward investments that give high rates of return, even if the net present value of the investment is very small.
- Using the marginal rate may lead to the rejection of large dollar-value projects, which can generate more cash for investors if their rate of return is small.
- The cost of capital is the basis for the marginal rate, and this concept may change over time.
The difference between the required rate of return and the internal rate of return
The marginal rate is the minimum that a company is expected to earn from an investment in a project. The internal rate of return is the interest rate at which the net present value of all positive and negative cash flows from a project equals zero.
In general, the marginal rate is equal to the company’s cost of capital, which is the sum of the cost of equity and the cost of debt. Managers often raise the threshold for higher-risk projects or when a company is comparing several investment opportunities.
The internal rate of return is used to calculate the expected return on stocks or investments, and although comparing it with the WACC is a fairly straightforward method for evaluating projects, this method has some limitations as an investment strategy. The internal rate of return can only be used when considering projects or investments that begin with an initial outflow of cash followed by one or more inflows. Also, this method does not take into account the possibility of a number of projects going on for different periods.
Read also: Things You Didn’t Know About Hedge Funds
