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.
Kavungya answered the question on April 13, 2021 at 06:33
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