The required rate of return (RRR) adjusted for inflation is the required rate of return after considering the effects of inflation. Recall that the required rate of return (also known as hurdle rate) is the minimum return that an investor is willing to accept for an investment.
What is the Required Rate of Return?
The required rate of return (RRR) is the benchmark used to determine the feasibility of an investment or project. If the return on an investment is less than the required rate of return, the investment or project should be rejected. Conversely, if the return on an investment exceeds its RRR, the investment or project should be undertaken.
Despite the importance of the required rate of return, this financial measure still comes with a flaw. The RRR is a nominal measure which does not take inflation into account. Inflation can be defined as a sustained increase in the general prices of goods and services in an economy that erodes the purchasing power of money. As a result, the nominal required rate of return, without considering the effects of inflation, may deliver a potentially misleading recommendation on the viability of an investment or project.
The RRR adjusted for inflation (also commonly referred to as the inflation-adjusted RRR) is especially useful in establishing different nominal hurdle rates for investments or projects in different countries that face substantially different inflation rates. For example, think about a company that is considering investments in the United States and Turkey. If we know what the company’s inflation-adjusted RRR is, we can calculate country-specific nominal RRRs for the United States and Turkey.
Formula for the RRR Adjusted for Inflation
First, let’s look at the formula for adjusting a nominal RRR to an inflation-adjusted RRR. The mathematical formula is:
RRR – the nominal required rate of return of an investment (does not consider the effect of inflation)
Example of the RRR Adjusted for Inflation
Let’s imagine that a company based in the United States has determined that its nominal RRR (or nominal hurdle rate) for investments or capital projects is 6.00%. Let’s also assume that the long-term inflation rate in the United States is expected to be 2.00%. The inflation-adjusted RRR for the company would be 3.92% and is calculated as follows:
In other words, the company should only proceed with investments or capital projects that deliver an inflation-adjusted return greater than 3.92%.
Example of Converting an RRR Adjusted for Inflation to a Nominal RRR
Let’s now imagine that this company is considering a new investment in Turkey where the long-term inflation rate is expected to be 5.00%. We need to ask the question, given that inflation is higher in Turkey, what should the nominal RRR be for investments in Turkey?
We can invert the formula above to get the answer. The formula to go from inflation-adjusted RRR to nominal RRR is as follows: