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The required rate of return is the minimum rate of return (expressed as a percentage) that an investor
requires before investing capital. The degree of risk associated with an investment is reflected in the
required rate of return. Investors and analysts often use the required rate of return as a discount rate for
future cash flows from an investment. The required rate of return is also referred to as RRR, the "Magic
Number" and the hurdle rate. For many investors, a beginning point in stock valuation is calculating the
required rate of return. The Capital Asset Pricing Model (CAPM) is a method used in determining the
required rate of return associated with an investment. On occasion, the required rate of return is confused
with the internal rate of return.

In securities, the minimum acceptable rate of return is at a given level of risk. Different investors have
different reasons for choosing their required returns. Normally, it is determined by a person's or
institution's cost of capital. For example, an investor may also carry a debt with a high interest rate; if an
investment does not meet a required rate of return, it would make more sense for the investor to pay down
his/her debt. The required return is also related to the amount of risk an investor is willing to accept. One
with a portfolio consisting largely of bonds will generally have a lower required return than one whose
portfolio contains mainly stocks.

Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm's
investors. It can also be defined as the rate of return on investments at which the price of a firm's equity
share will remain unchanged. Each type of capital used by the firm (debt, preference shares and equity)
should be incorporated into the cost of capital, with the relative importance of a particular source being
based on the percentage of the financing provided by each source of capital. Using of the cost a single
source of capital, as the hurdle rate is tempting to management, particularly when an investment is
financed entirely by debt. However, doing so is a mistake in logic and can cause problems.

Cost of capital is the minimal return that investors intend to earn on their investments. For shareholders,
the cost of capital is the dividend and capital gains on the share value, while for bondholders it is the
interest rate quoted on a bond. While investing, it is essential to consider the opportunity cost of the
invested capital, as it represents the return that is foregone by investors by choosing an alternative
investment opportunity that has similar or comparable risk. So, this factor may be considered while
calculating the cost of capital.

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.
The cost of capital is the rate of return that capital could be expected to earn in an alternative investment
of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable
to use the company's average cost of capital as a basis for the evaluation. A company's securities typically
include both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to
determine a company's cost of capital.
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The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice,
the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk
premium), which itself incorporates a probable rate of default (and amount of recovery given default). For
companies with similar risk or credit ratings, the interest rate is largely exogenous (not linked to the
company's activities).

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors.
Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return
required by investors, where the return is largely unknown. The cost of equity is therefore inferred by
comparing the investment to other investments (comparable) with similar risk profiles to determine the
"market" cost of equity.

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D1 = D (1 + g)
Di = 2.147= 2(1.07) =
K e = Dividend1 + g

Po=2.14 + 7%
= 9.3% + 7%
= 16.30%


234

Ki = Rf + B (Rm ± Rf)
= 9% + 1.20 (13% - 9%)
= 9% + 1.20 (4%)
= 9% + 4.8%
= 13.8%