Economics Capital Budgeting Questions
The profitability index (PI) 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 the project.
The formula to calculate the profitability index is as follows:
PI = Present Value of Cash Inflows / Present Value of Cash Outflows
To calculate the present value of cash inflows and outflows, the future cash flows are discounted using an appropriate discount rate. The discount rate is typically the project's required rate of return or the cost of capital.
If the profitability index is greater than 1, it indicates that the project is expected to generate positive net present value (NPV) and is considered financially viable. A PI less than 1 suggests that the project may not generate sufficient returns to cover the initial investment and is considered less attractive.
In summary, the profitability index provides a quantitative measure of the value created by an investment project, helping decision-makers assess its profitability and make informed investment decisions.