Explain the significance of a required rate of return.

Expert Solution

Return - Return is one of the important parameter in equity Investment

Expected return E(R) is compared with the required rate of return to calculate alpha i.e. abnormal return & decide upon taking long o short position.
Required rate is used for discount rate for valuation
It is one of the importance factor for equity investment. Re is also used while calculating NPV of the project. It helps to identify whether project is accepted or not. Re is compared with cost of capital, whether the Re> cost of capital project is accepted. If doing a new project, compare the Re with IRR of the project.

Required rate of return is calclated by differenent models-

CAPM - Re = RF + ( RM-Rf)*beta
Multifactor model - Re = Rf + FRP1B1 + FRP1B2 ........+ FRPkBk
Fama French Model - Re = Rf + ERPB1 +SMBB2 +HMLB

Note - B1 = beta1, B2 = beta2,.....Bk = betak

I hope this clear your doubt.

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jeff jeffy answered 1 year ago

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