Final answer:
The Internal Rate of Return approach is used by investors to evaluate the desirability of an investment by considering the present value of future payments at an interest rate that encompasses both the opportunity cost and a risk premium if necessary. An investment is deemed favorable if its IRR exceeds the required rate, here exemplified as 15%. Changes in risk or return can lead to shifts in financial capital allocations between different investments.
Step-by-step explanation:
Investment decision criteria generated with the Internal Rate of Return (IRR) approach involves a financial investor considering the present value of future payments based on an interest rate that captures the opportunity cost of financial capital and potentially a risk premium. In the context provided, the financial investor has decided on a 15% rate to assess the future payments. This rate reflects the competitive rates of return from other investment opportunities and additionally accounts for the risk associated with the investment, if it is higher than typical rates.
When making an investment decision, the investor will compare the IRR of the investment with the predetermined rate (in this case, 15%). If the IRR exceeds this rate, the investment is considered desirable, as it promises a return higher than the investor's required rate of return considering both opportunity cost and risk. The investor must carefully consider the actual rate of return, which includes all capital gains and interest earned, to determine if the investment meets their financial goals and compensates adequately for the risks taken.
If an investment's risk increases or its return diminishes, financial capital suppliers may alter their investment choices, shifting capital from the riskier or less profitable investment (Investment A), to a more favorable one (Investment B). This shift is represented by a movement in the supply curve of financial capital for both Investment A (leftward shift) and Investment B (rightward shift).