Final answer:
The rate of return on an investment is the percentage of gain or loss on the initial investment cost over a period, which influences the capital allocation decisions of investors. An effective rate of return incorporates both the cost of financial capital and any additional societal returns, resulting in financial investment modifications. Long-term investment strategies demonstrate the significance of compound interest and the impact of consistent rates of return.
Step-by-step explanation:
The rate of return on an investment is a crucial factor to consider when deciding where to allocate financial capital. It represents the gain or loss of an investment over a specified period as a percentage of the investment's initial cost. In a scenario where the interest rate is 9%, the cost of financial capital, and a firm can capture an additional 5% return to society, its effective rate of return would be 4% (interest rate of 9% minus the return to society of 5%). If a firm invests with these conditions, it would allocate $183 million at this effective rate of return. Risk, on the other hand, is viewed negatively by investors, and an increase in risk or a decrease in expected return can cause investors to shift their investments from one option to another, affecting the supply curves of financial capital for those investments.
As an illustration of the power of compound interest and rates of return, consider a long-term investment strategy. If an individual saves $3,000 at age 25 in a well-diversified stock portfolio, assuming a 7% real annual rate of return, the investment would grow almost fifteen-fold over 40 years, resulting in a future value of approximately $44,923.