Question

What is the difference between the expected rate of return and the required rate of return? What does it mean if they are different for a particular asset at a particular point in time? please a new and different answer. Thank you

Answer 1

The required rate of return is simply the cost of capital. So this is the return that a firm must earn to justify using the capital and stay financially viable because if the company earns less return than the cost of capital then it means the firm is losing money. For example, if a firm has arranged capital by issuing bonds at 7% yield to maturity, then it must earn at least a 7% rate of return from these funds just to be able to service its coupon payment and redemption obligations. Any return over & above this 7% would actually count towards the net value created from the project using this capital.

The expected rate of return on the other hand is that rate which a company (or any other investor) expects to earn from a particular investment given the risk level of the investment. If the investment is highly risky, the investor would expect a high rate of return to justify taking that risk. If the given project or investment cannot provide higher returns, the investor would be better off investing in lower-risk investment alternatives that provide a similar rate of return.

If these two rates are different for an asset at any point in time, then it means that the market value of the asset is not equal to its intrinsic value i.e. the asset will either be considered overvalued (if the required rate of return is more than the expected return) or undervalued (if the required rate of return is less than the expected rate of return).

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