The required rate of return is the minimum that a project or investment must earn before company management approves the necessary funds or renews funding for an existing project. It is the risk-free rate plus beta times a market premium. Beta measures a security's sensitivity to market volatility. Market premium is the market return minus the risk-free rate, which is usually the three-month Treasury bill rate. Factors affecting the required rate include interest rates, risk, market returns and the overall economy.
Changes in short-term interest rates, usually because of U.S. Federal Reserve action, lead to changes in other short-term and long-term rates, including U.S. Treasury bill rates. This changes the base risk-free rate and thus the required rate of return. For example, if the Fed tightens monetary policy by increasing short-term rates, risk-free U.S. Treasury rates will rise, thus increasing the required rate of return. Conversely, when the Fed lowers rates, the required rate of return falls.
Rates of return might be affected by risk factors outside management's control. According to New York University professor Aswath Damodaran, these risks include business risk, project risk and market risk. Business risk refers to competitive pressures, industry risk and international risk. Industry risk includes a changing regulatory environment, evolving technologies and the risk of rising raw material prices. International risk entails political instability and currency fluctuations. Liquidity risk means that a company could face serious financial difficulty and run out of cash. The required rate of return is higher when the risks are high, and lower when the risks are low.
Changes in market returns affect the required rate of return. Market returns depend on several factors, such as corporate profits, interest rates, geopolitical events and natural disasters. For example, the civil unrest in North Africa and across the Middle East in late 2010 and early 2011 affected global market returns. The 2011 Japanese earthquake affected Japanese stock exchanges, as well as markets in China, Europe and the United States. The 2008 financial crisis hit the United States first, but markets elsewhere soon felt the impact.
The economy affects the required rate of return. Corporate profits fall in a recession and rise when economic growth picks up. Markets rise and fall with corporate profits, which affects the market premium component of the required rate. Economic uncertainty tends to increase the volatility of securities, which affects the beta component. Globalization means that changes in the economic conditions of one country could affect businesses in multiple countries, and thus the required rate of return for companies doing business in those countries.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.