Required Rate of Return (R_{i})
The required rate of return (Ri) is the minimum rate of return that a project must generate if it has to receive funds. It’s thus the opportunity cost of capital or returns predictable from the second best option. In common,
Required Rate of Return = Risk-free rate + Risk premium
Risk free rate is compensation for time and is made up of the real rate of return (R_{r}) and the inflation premium (IRp). The risk premium is reimbursement for risk of financial actions exhibiting:- The riskiness of securities caused by term to maturity- The security liquidity and marketability- The consequence of exchange rate fluctuations on the security, and so on.The requisite rate of return can hence be expressed as follows:
R_{j} = R_{r }+IR_{p} +DR_{p} +MR_{p} + LR_{p} + ER_{p} + SR_{p} + OR_{p}.Where:
1) R_{r} is the actual rate of return which compensates investors for giving up the utilization of their finances in inflation free and risk free market.2) IR_{p} is the Inflation Risk Premium that compensates the investor for the reduction in purchasing power of capital caused by inflation.3) DR_{p} is the Default Risk Premium that compensates the investor for the possibility that users of finances would be unable to pay back the debts.4) MR_{p} is the Maturity Risk Premium that compensates for the term to maturity.5) LR_{p} is the Liquidity Risk Premium that compensates the investor for the option that the securities given are not simply marketable (or convertible to cash).6) ER_{p} is the Exchange Risk Premium that compensates the investors for the fluctuation in exchange rate. This is mostly significant when the funds are denominated in foreign currencies.7) SR_{p} is the Sovereign Risk Premium that compensates the investors for the option of political instability in the country in which the funds have been given.8) OR_{p} is the Other Risk Premium example, the kind of product, the type of market, and so on.