Dr. Clark holds a CFA designation and specializes in portfolio management, security valuation, and advanced risk assessment models like the Capital Asset Pricing Model (CAPM).
The **Required Rate of Return Calculator** uses the Capital Asset Pricing Model (CAPM) to determine the theoretical return an investor should expect for taking on a certain level of systematic risk. **Input any three of the four core variables** (Required Return Rr, Risk-Free Rate Rf, Market Return Rm, or Beta $\beta$) to solve for the missing fourth value.
Required Rate of Return Calculator (CAPM)
Required Rate of Return Formula (CAPM)
The calculation is based on the foundational Capital Asset Pricing Model (CAPM):
Formula Source: Investopedia: Capital Asset Pricing Model
Variables Explained
Understanding the components is crucial for correctly interpreting the required return:
- Required Return ($R_r$): The expected rate of return for the security based on its systematic risk.
- Risk-Free Rate ($R_f$): The return on a theoretical investment with zero risk (e.g., the yield on short-term U.S. Treasury bonds).
- Expected Market Return ($R_m$): The expected return of the overall market (e.g., S&P 500 index) over the period.
- Stock Beta ($\beta$): A measure of the asset’s volatility relative to the overall market. A beta of 1 means the stock moves with the market.
Related Calculators
Deepen your investment and valuation analysis with these related financial tools:
What is the Required Rate of Return?
The **Required Rate of Return ($R_r$)** is the minimum rate of return an investor must expect to receive from an investment to compensate them for its level of risk. In the context of CAPM, this risk is specifically **systematic risk** (non-diversifiable risk). If the expected return of an investment falls below its $R_r$, the investment should be avoided, as the compensation for risk is insufficient.
The $R_r$ consists of two parts: the Risk-Free Rate ($R_f$) and the Risk Premium. The Risk Premium, $\beta(R_m – R_f)$, is the additional return demanded by the investor for taking on the specific systematic risk of the asset, quantified by its Beta ($\beta$). For companies, the $R_r$ is often used as the cost of equity (Re) when calculating the Weighted Average Cost of Capital (WACC).
How to Calculate Required Return (Example)
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Gather Market Data:
The **Risk-Free Rate ($R_f$)** is **3.0\%**, the **Expected Market Return ($R_m$)** is **10.0\%**, and the stock’s **Beta ($\beta$)** is **1.2**.
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Calculate the Market Risk Premium:
Market Risk Premium is $R_m – R_f = 10.0\% – 3.0\% = \mathbf{7.0\%}$. This is the excess return the market provides over the risk-free rate.
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Calculate the Asset’s Risk Premium:
Asset Risk Premium is $\beta \times (R_m – R_f) = 1.2 \times 7.0\% = \mathbf{8.4\%}$.
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Determine the Required Return:
Apply CAPM: $R_r = R_f + \text{Risk Premium} = 3.0\% + 8.4\% = \mathbf{11.4\%}$. This means the investor demands an 11.4\% return for this stock.
Frequently Asked Questions (FAQ)
A: The $R_f$ is the baseline return an investor should get simply for lending money for a period of time, even with zero risk. The Required Return ($R_r$) must always be at least the risk-free rate.
A: A beta of 1.5 means the stock is 50\% more volatile than the market. If the market goes up 10\%, the stock is expected to go up 15\%. Investors require a higher return for this increased volatility (risk).
A: Yes. Because CAPM is a linear equation, if you know the Required Return and any two other variables, you can algebraically solve for the missing fourth variable, such as the required Beta or the implied Market Return.
A: Yes, for publicly traded companies, the $R_r$ calculated using CAPM is widely accepted as the **Cost of Equity** ($R_e$), which is the return shareholders expect to earn on their investment.