what does the required rate of return tell you 
the required rate of return rrr is a key concept in equity valuation and corporate finance it s a difficult metric to pinpoint due to the different investment goals and risk tolerances of individual investors and companies risk return preferences inflation expectations and a company s capital structure all play a role in determining the company s own required rate each one of these and other factors can have major effects on a security s intrinsic value for investors using the capm formula the required rate of return for a stock with a high beta relative to the market should have a higher rrr the higher rrr relative to other investments with low betas is necessary to compensate investors for the added level of risk associated with investing in the higher beta stock in other words rrr is in part calculated by adding the risk premium to the expected risk free rate of return to account for the added volatility and subsequent risk for capital projects rrr is useful in determining whether to pursue one project versus another the rrr is what s needed to go ahead with the project although some projects might not meet the rrr but are in the long term best interests of the company to accurately calculate the rrr and make it more meaningful the investor must also consider their cost of capital as well as the return available from other competing investments in addition inflation must also be factored into rrr analysis so as to obtain the real or inflation adjusted rate of return example of rrr using the dividend discount model ddm a company is expected to pay an annual dividend of 3 next year and its stock is currently trading at 100 a share the company has been steadily raising its dividend each year at a 4 growth rate example of rrr using the capital asset pricing model capm in the capital asset pricing model capm rrr can be calculated using the beta of a security or risk coefficient as well as the excess return that investing in the stock pays over a risk free rate called the equity risk premium assume the following let s say company a has a beta of 1 50 meaning that it is riskier than the overall market which has a beta of 1 to invest in company a rrr 14 or 2 1 50 x 10 2 company b has a beta of 0 50 which implies that it is less risky than the overall market to invest in company b rrr 6 or 2 0 50 x 10 2 thus an investor evaluating the merits of investing in company a versus company b would require a significantly higher rate of return from company a because of its much higher beta required rate of return vs cost of capitalalthough the required rate of return is used in capital budgeting projects rrr is not the same level of return that s needed to cover the cost of capital the cost of capital is the minimum return needed to cover the cost of debt and equity issuance to raise funds for the project the cost of capital is the lowest return needed to account for the capital structure the rrr should always be higher than the cost of capital limitations of the required rate of returnthe rrr calculation does not factor in inflation expectations since rising prices erode investment gains however inflation expectations are subjective and can be wrong also the rrr will vary between investors with different risk tolerance levels a retiree will have a lower risk tolerance than an investor who recently graduated college as a result the rrr is a subjective rate of return rrr does not factor in the liquidity of an investment if an investment can t be sold for a period of time the security will likely carry a higher risk than one that s more liquid also comparing stocks in different industries can be difficult since the risk or beta will be different as with any financial ratio or metric it s best to utilize multiple ratios in your analysis when considering investment opportunities 