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Question
What is the profitability index? When is it used?
Step-by-Step Solution
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Answer
The profitability index aids in classifying investments and selecting the best one to make. A PI value greater than one implies that the investment will generate profits since the present value of expected future cash inflows from the investment is greater than the initial investment.
1Step 1: Use of Profitability index
When a business has a number of potential investments and initiatives, it uses them to compare and contrast them. The index can be used in conjunction with other criteria to decide which investment is the best.
2Step 2: Advantages
Through the cost of capital, it considers both the future cash flow risk and the time value of money. When capital is rationed, it helps with ranking and selecting amongst projects.