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The required rate of return (RRR) is the minimum return which an investor expects from its business. It is used in corporate finance to evaluate the projects. By the using of RRR, businesses analyze the profitability of potential projects.
How to determine RRR?
Suppose, you have an FDR of $5000 in a bank in a 12% interest. It means you earn $600 every year from the deposit (we consider simple interest rate). Now, you decided to invest this $5000 to start an ice cream factory instead of keeping in FDR account. What do you think before invest?
You should think about two conditions:
01. You must invest the money in such project which’s outcome is more than 12%.
02. You must consider cost of your risk.
Yes, why you have invested such a project which will not give you a better outcome than FDR? So, 12 % interest is your opportunity cost because you left the opportunity of yearly secure income of $600 (12%) to invest in an ice cream factory. And you take a risk for the business. If you lose the business you miss out fixed earnings. So, you must consider a percentage of risk premiums in your required rate. You think your risk premium will be 3%. So, the required rate of return will be 15%.
Therefore, the required rate of return= Opportunity cost + risk premium. (12%+3%=15%)
How you choose a project on the basis of RRR?
Your mindset that if you get 15% returns from the ice cream business you will invest in the project. Now you need to see what is the Net present value (NPV) of the investment.
- If the project has NPV =$0, then the project generates exactly enough cash flows to recover the cost of the investment and to enable you to earn their required rates of return (the opportunity cost of capital).
- If the NPV is positive (NPV>0), then more than enough cash flow is generated
- On the other hand, if the NPV of a project is negative (NPV<0) it is rejected upon the reasoning that it does not beneficial for you.
In case of your ice cream factory, you assume that cash inflow for five-year will be $800, $1000, $1500, $2500 & $2300 respectively. Your NPV is $10.96; which is greater than $0. So, you should accept the project.
Internal rate of return (IRR)
Internal rate of return is used to analyze how much an investment or project will be attractive. If the IRR of a new project is higher than the company’s required rate of return that projects are acceptable and if the IRR less than RRR the project should be rejected.
So, to start the ice cream factory your required rate of return is 15%. Now you calculated IRR and found it is 15.08%; that means IRR>RRR. So you accept the project because-
- If a project’s IRR=RRR, then its cash flows are just sufficient to provide required rates of return. In this case, we may accept the project
- If a project’s IRR>RRR that implies an economic profit, in such situation we should accept the project.
- If IRR<RRR that indicates an economic loss, or a project that will not earn enough to cover its required rate of return. You must avoid the project on such a condition.
If you want to judge a project wheater it will be accepted or not, calculate the NPV (at the rate of RRR). If the NPV is higher or equal to zero you should accept the project. If it is negative, reject the projects.
You should also justify the internal return. If it is equal or higher than the required rate you should accept the project. It is less than RRR, reject the project.
A short hints for next blog:
In the case of Independent Project: If NPV supports a project, IRR also supports the project.
In case of Mutual Exclusive Project: If NPV support a project, IRR will not support the project.
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