A software company is evaluating a potential investment in a new product line. The company’s cost of capital is 12%, and management must decide whether this project is worth pursuing based on its profitability. Analysts are currently calculating this project’s internal rate of return (IRR). Which IRR would indicate that this is a profitable project?

Rationale

An IRR of 14% would indicate that this is a profitable project.

An internal rate of return (IRR) greater than the company's cost of capital signifies a profitable investment, as it indicates that the project's returns exceed the minimum required return of 12%. Therefore, an IRR of 14% demonstrates the project’s potential for profitability.

A (12%) YOUR ANSWER

An IRR of 12% matches the company's cost of capital, indicating that the project is expected to break even. While not a loss, it does not provide any additional profit over the cost of financing, making it an unattractive investment.

B (14%) CORRECT

An IRR of 14% exceeds the cost of capital at 12%, suggesting that the project is expected to generate returns above the required threshold. This indicates a profitable investment opportunity, as the project can generate sufficient returns to cover its costs and provide a surplus.

C (10%) YOUR ANSWER

An IRR of 10% falls below the company’s cost of capital of 12%. This suggests that the project would fail to meet the minimum profitability requirement and would likely result in a financial loss, making it an unwise investment.

D (8%) YOUR ANSWER

An IRR of 8% is significantly lower than the cost of capital of 12%. This indicates that the project's returns are inadequate to cover the cost of financing, resulting in a negative net present value and making it a poor investment choice.

Conclusion

In evaluating the profitability of a project, an IRR greater than the cost of capital is essential. The IRR of 14% indicates that the project not only meets but exceeds this threshold, confirming its status as a profitable investment. In contrast, IRRs of 12%, 10%, and 8% suggest insufficient returns to justify the investment, reinforcing the importance of selecting projects with favorable IRRs relative to the cost of capital.

An IRR of 14% would indicate that this is a profitable project.

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