Final answer:
It is false that an investment with an IRR lower than the cost of capital will provide a return on the unrecovered investment and the recovery of the investment. The IRR should exceed the cost of capital to be profitable, and it reflects the potential efficiency of an investment. Investment decisions are affected by the dynamic relationship between rate of return, risk, and how capital is supplied to diverse financial investments.
Step-by-step explanation:
If the Internal Rate of Return (IRR) is less than the cost of acquiring capital, it is false to say the investment will provide a return on the unrecovered investment as well as the recovery of the investment. The Internal Rate of Return is a metric used to evaluate the profitability of potential investments.
It is the rate at which the net present value of all the cash flows (both positive and negative) from an investment equal zero. Essentially, the IRR can be understood as the break-even interest rate that makes an investment worth pursuing; it represents the efficiency, quality, or yield of an investment.
When the IRR on a project or an investment is lower than the cost of capital, which could be the interest rate on borrowed funds or the required rate of return for equity investors, the investment is considered to be underperforming. An investment should ideally have an IRR that exceeds the cost of capital to be deemed acceptable, as this indicates that it can recover the investment and generate an additional return. If the IRR is below the cost of capital, the investment is not expected to cover its own costs and thus will not yield a positive financial return, leading to a potential loss for the investor.
Understanding the relationship between the rate of return and risk is crucial for financial investment decisions. Rate of return informs the investor about the potential profit an investment can generate, which is generally sought to be maximized. In contrast, risk represents the uncertainty that the actual returns may differ from the expected ones, potentially resulting in losses.
This risk-return tradeoff influences how capital is allocated among various investment opportunities. If an investment becomes riskier or its expected rate of return decreases, investors are likely to move their capital to more attractive investments, impacting the supply curve for capital of those investments accordingly. Such shifts in capital supply can help balance the risk and return expectations of investors within the market.