Question

What are the three factors that influence the required rate of return by investors?

Short answer

Three factors affecting the required rate of return are – the real rate of return, inflation premium, and risk premium.

Step-by-step solution

Required rate of return

The required rate of return is based on the market’s perceived risk for any individual security. This perceived risk has two risk components – business risk and financial risk. This perceived risk generates the risk premium.

Factors affecting the required rate of return

As given, the required rate of return is the result of a risk-free rate and risk premium. The risk premium is the result of associated risk with security. The risk-free rate results from the real rate of return and inflation premium.

So the three factors affecting the required rate of return are –

i) Real rate of return

ii) Inflation premium

iii) Risk premium

The required rate of return is the summation of all these three factors.