Required Rate of Return (Ri)
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 (Rr) 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:
Rj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp.Where:
1) Rr 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) IRp is the Inflation Risk Premium that compensates the investor for the reduction in purchasing power of capital caused by inflation.3) DRp 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) MRp is the Maturity Risk Premium that compensates for the term to maturity.5) LRp 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) ERp 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) SRp 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) ORp is the Other Risk Premium example, the kind of product, the type of market, and so on.