Certified Financial Management Specialist Practice Exam

Which investment criterion indicates the long-term profitability of a project?

1. Net Present Value (NPV)

2. Payback Period

3. Cash Flow Analysis

4. Internal Rate of Return (IRR)

The correct answer is: Internal Rate of Return (IRR)

The long-term profitability of a project is best indicated by the Internal Rate of Return (IRR). IRR represents the discount rate at which the net present value of all cash flows from a project equals zero. In simpler terms, it is the rate of growth a project is expected to generate and helps determine whether to proceed with the investment. A higher IRR value suggests that the investment is likely to yield a more significant return, making it a critical measure for long-term profitability. Compared to other criteria, the Payback Period focuses solely on how quickly an investment can be recouped, without accounting for the time value of money or the profitability beyond the payback threshold. Net Present Value (NPV) reflects the difference between the present value of cash inflows and outflows but does not provide a rate of return that can be easily compared across different investments. Cash Flow Analysis is a broader concept that includes the examination of inflows and outflows over time, rather than providing a specific percentage return like IRR. Hence, IRR is particularly valuable when evaluating the potential long-term profitability of a project.