What it means
Money has an opportunity cost, because any dollar put into one project is a dollar not available for another or for returning to shareholders. The required rate of return puts a number on that opportunity cost, blending a risk-free return with extra compensation for the specific risks being taken.
In a business setting it usually appears as the discount rate in a net present value calculation or as the hurdle rate a project must clear. If a proposal's internal rate of return sits below the required rate, the project is expected to leave investors worse off than the alternatives available to them.
The most common way of estimating it for equity is the capital asset pricing model, which starts from a risk-free rate, then adds a market risk premium scaled by beta, a measure of how much an investment's returns move relative to the market as a whole. A beta above one implies more volatility than the market and therefore a higher required return.
Companies often use their weighted average cost of capital as a group-wide required return, then adjust it upward for projects that are riskier than the existing business. Applying one rate to everything from a routine equipment replacement to an untested overseas launch quietly favours the risky project.
Precision here is illusory, and that is fine. The point of the required rate of return is to force an honest conversation about risk and alternatives, so most disciplined teams test their decisions across a range of rates rather than defending a single figure to two decimal places.
In practice
Real-world examples
Example 1
A private investor comparing a corporate bond yielding 6% with a start-up equity stake decides the start-up must offer at least 25% expected annual return to compensate for the much higher chance of losing everything. The start-up projects 15%, so the investor declines.
Example 2
A manufacturer applies a 9% hurdle rate to domestic equipment purchases but 15% to a proposed plant in a new country with currency and political risk. Two projects with identical returns of 12% therefore get different answers.
Example 3
A property fund raises money promising investors a 10% annual return. Any building it buys must be expected to deliver more than 10% after costs and financing, so at current prices the fund passes on deals it would have bought two years ago.
Think of it
Think of the required rate of return like clearing a high jump bar. If the bar is set at one metre, you only need a small effort. If it is set at two metres, you need a much bigger jump to succeed.
Formula
Calculation
Required rate of return = Risk-free rate + beta x (expected market return - risk-free rate)
A company is assessing a project with the same risk profile as its own equity. The risk-free rate is 4%, the expected return on the broad market is 9%, so the market risk premium is 9% - 4% = 5%. The company's beta is 1.3, so the required rate of return is 4% + (1.3 x 5%) = 4% + 6.5% = 10.5%. To see what that means in cash, a project expected to generate $525,000 a year indefinitely is worth $525,000 / 0.105 = $5,000,000 at that required return. If the asking price is $4,600,000 the project creates $400,000 of value, while at $5,400,000 it destroys $400,000, even though the annual cash flow is identical in both cases.Case study
Seen in the real world
Thornbury Coatings is an illustrative and fictional specialist paint manufacturer whose board approved capital projects using a single 8% hurdle rate for everything. Over four years it built a solid record on factory upgrades and a poor one on new market ventures.
A new finance director grouped past projects by type. Equipment replacement had reliably beaten 8%, while overseas expansion had averaged well below it once delays and currency losses were counted, yet both had been approved on the same test.
Thornbury moved to three required rates in this illustrative example: 7% for replacement and maintenance, 11% for expansion in existing markets and 16% for genuinely new territories. Two proposed ventures failed the higher test in the first year, and the capital went into a capacity expansion that comfortably cleared 11%.
Watch out
Common mistakes
- Using one company-wide required return for every project regardless of risk, which systematically approves risky proposals and rejects safe ones.
- Comparing an accounting return such as return on capital employed directly against a required rate built from cash flows and discounting.
- Setting the rate so high that nothing is ever approved, which is a common way of disguising an unwillingness to invest.
Questions
People also ask
Is the required rate of return the same as the cost of capital?
They are closely related; cost of capital is what the company pays for funds, and the required rate of return is the minimum an investment must earn to justify using those funds.
Does inflation belong in the required rate?
Yes if the cash flows being discounted are in nominal terms, which is usual; if the cash flows are in real terms then a real required return should be used instead.
What if a project is strategic but fails the test?
Approve it if you wish, but record the shortfall openly as the price of the strategic benefit rather than adjusting the rate until the answer looks acceptable.