Determinants of Required Rates of Return

Required Rates of return is one of the key factors which influence an investment decision. Actually, Determinants of Required Rates of Return helps to calculate the required rates of return on an investment. Sometimes the required rates of return are considered as the cost of capital/expected rates of return which basically used as a discounting or compounding factor. By using this factor, we actually calculate the present and future value of cash flows.

Determinants of Required Rates of Return

Here, determining factors are getting more important because this help to find out what should be our minimum required rates of return on investment. But the question is what are the determinants of required rates of return?

Determinants of Required Rates of Return

There are three broad determinants of Required Rates of Return and these are as follows:

  1. Time Value of Money
  2. Expected Rate of Inflation for a particular economy
  3. Involvement of Risk on Investment

Time Value of Money

  • The present value of money
  • Future value of money

Expected Rate of Inflation (Decline in Purchasing Power of Money)

Every economy may have inflation which is alright up to a considerable percent but exceeding inflation is not good for the economy. At the time of calculating expected rates of return, we must consider inflation. Higher the inflation, higher the required rates of return. It is a central bank and government responsibility to adopt an effective economic policy by which an accepted rate of inflation can be there for an economy. Investment selection process is influenced by the required rate of inflation.

Involvement of Risk with Investment

You know, there is nothing where risk is not involved. And it is money we talk about is more sensitive towards risk. Risk can vary from industry to industry, company to company, person to person. But the common thing is higher the risk higher the rates of return person expect from an investment. Although you may find there is a variation of risk-taking behavior among the individuals which is influenced by the personal trait of an individual. Risk can be broadly categorized into two head; one is systematic and other is an unsystematic risk.

  • Systematic Risk: Directly involved with the system which arises from the macroeconomic factors and it is not possible to minimize this type of risk through diversification of investment.
  • Unsystematic Risk: Unsystematic is a type of risk which is possible to minimize through diversification of investment. With this risk, there is a correlation between risk and diversification.

The determination process is involved with complicated work because the process is depending on how market change over time and how investors behave with it.

Market change because of the following reasons

  • A wide range of available investment alternatives
  • Return on specific assets change dramatically
  • Change in interest rate over the time period

It does not necessarily need to be the same required rates of return for all the people. The rate will vary according to the economic factors and the personal risk-taking behavior of an individual. So it will be better for you if you identify the influencing factors and then calculate your required rates of return on investment.

Determinants of Time Value of Money

What are the determinants of the time value of money? Time value of money is the most important concept of finance. The main thing of the time value of money is that the value of dollar 100 now is more than the value of dollar 100 after some time. That is the value of money today is more than the value of money after some time. When making any investing or financing decision we have to consider this idea, otherwise, we may incur some loss of benefit. To calculate the present value of any fund this time value concept is used to identify the required rates of return.

The Idea that money available at the present time is worth more than the same amount in the future because of the potentiality of future earnings. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received.

Determinants of the time value of money

There are several determinants which are used to calculate the actual value of the money. Four commonly used determinants are:

  1. Consumption preference of a person
  2. Uncertainty of future
  3. Inflation of the economy
  4. Investment Opportunity

determinants of time value of money

Consumption preference of a person

People prefer current consumption to future consumption if there is the same level of satisfaction. Most of the people are ready to sacrifice the current consumption if they find that in the future they will be able to consume more than the present. A higher rate of return that is more than the required rates of return is mainly leading them to take the decision of sacrifice of current consumption. Some people think that the future is uncertain so it’s better to consume now although they are not concern about the benefit of future.

Uncertainty of future

Future is always uncertain. Nobody knows what will happen in the future. So it is better to consume now rather than consume in the future if current consumption rate is more. People would like to compensate for uncertain future cash flow against certain cash flow.

Inflation of the economy

Inflation is related with the purchasing power of money. With the time the purchasing power of money is decreased. Every economy has inflation but the rate is different from country to country economy. If there is higher inflation then the required rates of return of investor are higher. For a higher inflationary economy, consumers prefer current consumption rather than future consumption.

Investment opportunity

Time value of money considers the idea of reinvestment that is if an investment generates cash inflow periodically then this periodic return can be reinvested which will generate a higher return. If the cash flow comes now, it can be invested and generate additional cash flow, therefore whatever may be the cash flow now. The future cash flow is more than its present cash flow.

If you like this article please do not forget to share on facebook and put your valuable comment.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

Facebook: Ördïnärÿ Böÿ