Economics Capital Budgeting Questions Medium
The profitability index, also known as the profit investment ratio (PIR) or the value investment ratio (VIR), is a financial metric used in capital budgeting to evaluate the profitability of an investment project. It measures the relationship between the present value of cash inflows and the present value of cash outflows associated with a project.
The profitability index is calculated by dividing the present value of cash inflows by the present value of cash outflows. The formula for calculating the profitability index is as follows:
Profitability Index = Present Value of Cash Inflows / Present Value of Cash Outflows
To calculate the present value of cash inflows and outflows, the future cash flows associated with the project are discounted to their present value using an appropriate discount rate. The discount rate used is typically the project's required rate of return or the cost of capital.
A profitability index greater than 1 indicates that the project is expected to generate positive net present value (NPV) and is considered financially attractive. On the other hand, a profitability index less than 1 suggests that the project is expected to result in negative NPV and may not be financially viable.
In capital budgeting decisions, projects with higher profitability indices are generally preferred as they offer higher returns relative to the investment made. However, it is important to consider other factors such as the project's risk, payback period, and strategic alignment before making a final investment decision.