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 therefore the opportunity cost of capital or returns expected from the second best alternative. In general,

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 compensation for risk of financial actions reflecting:

           The riskiness of the securities caused by term to maturity

The security marketability or liquidity

The effect of exchange rate fluctuations on the security, etc

The required rate of return can therefore be expressed as follows:

Rj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp.

Where:

  • Rr is the real rate of return that compensate investors for giving up the use of their funds in an inflation free and risk free market.

  • IRp is the Inflation Risk Premium which compensates the investor for the decrease in purchasing power of money caused by inflation.

  • DRp is the Default Risk Premium which compensates the investor for the possibility that users of funds would be unable to repay the debts.

  • MRp is the Maturity Risk Premium which compensates for the term to maturity.

  • LRp is the Liquidity Risk Premium which compensates the investor for the possibility that the securities given are not easily marketable (or convertible to cash).

  • ERp is the Exchange Risk Premium which compensates the investors for the fluctuation in exchange rate. This is mainly important if the funds are denominated in foreign currencies.

  • SRp is the Sovereign Risk Premium which compensates the investors for the possibility of political instability in the country in which the funds have been provided.

  • ORp is the Other Risk Premium e.g. the type of product, the type of market, etc.