How to Identify the Required Rate of Return on an Investment
The required rate of return (RRR or "hurdle rate") is a percentage that describes how much money an investor would need to make on the money they invest in order to make the investment worthwhile. Not only do you need to make money, but you need to make more money on that investment than you would on any other investment of a similar risk level and time frame. A return of less than the RRR would result in deciding not to make the investment.
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Instructions
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Set up the problem. You'll need to know how much money you're investing, what the time period of the investment is, what the risk level is in comparison with the risk-free rate, and what other possible investments you might make, or which debts you might pay off for the same amount of money. You'll need to calculate the rate of return for each possible investment, or the interest rate on the debt, in order to compare them against each other.
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Establish the time frame of the investment. A start-up company may take three to five years to return the investment with no dividend payout in the meantime; whereas, an apartment building might be held indefinitely while rental payments come in every month.
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Calculate the future value of the money invested at the exit date. Since inflation means that $1 tomorrow is worth less than $1 today, you'll have to calculate approximately how much today's money will be worth at the end of the investment period. No one knows for sure what the inflation will be, but in the United States it averages 2 percent to 3 percent a year.
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Look up the risk-free return rate. This is the percentage paid to investors who hold assets that are considered to be guaranteed. Most calculations assume that United States Treasury Bills are risk-free, so estimate the interest rate on Treasury Bills over the investment period. Historically this rate averages 3 percent to 4 percent but it can vary dramatically from year to year.
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Determine the risk premium. Generally speaking, the longer the investment time frame, the higher the premium. If you're investing in stocks, you can use the "beta" value of the stock, which is a published figure that reflects how volatile the stock is, or how much it changes in value from day to day. By definition, the stock market as a whole has a beta value of 1. Stocks that are close to a beta value of 1 have a risk premium that is the same as the entire market's risk. Stocks that have a beta value of 2 or -1 are very volatile and should be priced much more highly than the market. Essentially, you will compare the risk of the investment against the risk of investing in an index fund. This step is, by far, the most subjective since risk, by definition, is unknown.
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Add the values. If you are evaluating a moderately risky $10,000 investment that pays out at the end of two years, add the value of inflation compounded over two years, plus the risk-free return rate, plus the risk premium. You might come up with a figure of, say, 12 percent.
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Evaluate your other options. If you're paying 13 percent interest on $10,000 worth of credit card debt, then the investment falls below your required rate of return. If another option in the market is a $10,000 investment with an 11 percent return, but the investment you've been looking at is slightly more risky, 12 percent is your required rate of return for that investment.
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Tips & Warnings
If you're borrowing in order to invest, or are taking the money out of another productive investment in order to make a new investment, you'll also need to factor in the cost of funds.
