required rate of return ri the required rate

Question

Required Rate of Return (R_i) 

The required rate of return (Ri) is the minimum rate of return that a project must generate if it has to receive funds.  It’s thus the opportunity cost of capital or returns predictable from the second best option. In common,

Required Rate of Return = Risk-free rate + Risk premium

Risk free rate is compensation for time and is made up of the real rate of return (R_r) and the inflation premium (IRp). The risk premium is reimbursement for risk of financial actions exhibiting:

-    The riskiness of securities caused by term to maturity
-    The security liquidity and marketability
-    The consequence of exchange rate fluctuations on the security, and so on.

The requisite rate of return can hence be expressed as follows:

R_j = R_r +IR_p +DR_p +MR_p + LR_p + ER_p + SR_p + OR_p.

Where:

1) R_r is the actual rate of return which compensates investors for giving up the utilization of their finances in inflation free and risk free market.

2) IR_p is the Inflation Risk Premium that compensates the investor for the reduction in purchasing power of capital caused by inflation.

3) DR_p is the Default Risk Premium that compensates the investor for the possibility that users of finances would be unable to pay back the debts.

4) MR_p is the Maturity Risk Premium that compensates for the term to maturity.

5) LR_p is the Liquidity Risk Premium that compensates the investor for the option that the securities given are not simply marketable (or convertible to cash).
6) ER_p is the Exchange Risk Premium that compensates the investors for the fluctuation in exchange rate. This is mostly significant when the funds are denominated in foreign currencies.

7) SR_p is the Sovereign Risk Premium that compensates the investors for the option of political instability in the country in which the funds have been given.

8) OR_p is the Other Risk Premium example, the kind of product, the type of market, and so on.