Profitability index (PI)

Definition

Profitability Index (PI) measures the ratio of the present value of future cash flows to the initial investment. It is used to assess the attractiveness of an investment.

5 Must Know Facts For Your Next Test

1. A PI greater than 1 indicates that the investment is likely profitable.
2. PI is calculated as Present Value of Future Cash Flows / Initial Investment.
3. It helps in comparing and ranking projects based on their profitability.
4. Projects with higher PI values are generally preferred when resources are limited.
5. PI can be used alongside other metrics like Net Present Value (NPV) and Internal Rate of Return (IRR).

Review Questions

• What does a Profitability Index greater than 1 signify?
• How do you calculate the Profitability Index?
• Why might companies prefer projects with higher PI values?

Related terms

Net Present Value (NPV): NPV calculates the difference between the present value of cash inflows and outflows over a period of time.

Internal Rate of Return (IRR): IRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero.

Payback Period: Payback Period measures how long it takes for an investment to generate an amount of cash flow sufficient to recover its initial cost.