Required rate of return is the percentage of earnings which a certain asset should bring in order to become a worthwhile investment for the capital owners. The notion may apply to valuation of both securities and business projects, and is utilized in the field of equity valuation as well as corporate finance. In the latter case, required rate of return is also referred to as WACC (weighted average cost of capital). In general, required rate of return is the benchmark against which profitability of various project is evaluated.
The macroeconomic factors which affect required rate of return include levels of inflation, risk-free rate and liquidity of the considered asset. Among microeconomic, individual- or company-specific factors of influence to required rate of return there are level of risk tolerance, details to investment strategy and other situational features.If the monetary policy gets tighter, and risk-free rate in the economy goes up, it also pushes up required rates of return, as now it becomes possible to gain relatively higher returns without taking on unnecessary risks.
Relationship between required return and inflation is also positive, as higher inflation means lower real earnings, and lower incentive to invest at any given particular nominal rate.Higher liquidity of an asset would mean relatively lower required rate of return, as it is associated with lower transaction costs of changing investment mix, if such a necessity arises. Lower risk tolerance would imply higher required returns, as opportunity cost of undertaking a risk is evaluated higher for such kind of a company or individual investor. Influence of the investment mix preferences can vary, being revealed in a premium which an investor is willing to pay for some kinds of projects or securities as opposed to others. This can happen for instance, if company specializes in specific industry or sector and is willing to invest money prevalently there.Capital market is a financial infrastructure unit which is used as a platform for selling equity and debt financial instruments. Within their framework, excess funds of some stakeholders are channeled into the projects or investments of others, who at the moment lack them and are willing to pay a premium.
Therefore, main purpose of capital markets is efficient funds allocation and reducing transaction costs associated with this process. Its main three components are the stock market, the bond market and the money market (Reilly & Brown, 2011). Looking from the other perspective, it is also possible to define primary markets (initial security offerings) and secondary (those trading already issued securities). Scope of the capital market of a particular state is closely connected to the size of its economy and overall level of institutional development.
Functions of the capital markets are as follows:
Mobilizes savings – that is, at any given moment ensures optimal allocation of funds in the economy;
Promotes capital formation – being allocated optimally, actual amount of capital for use in the economy increases, generating additional investment streams into sectors such as agriculture, industry and others;
Facilitates longer-term investments – with developed capital markets, it is …