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Define the profitability index and explain how it may be used a criterion for determining whether...

Define the profitability index and explain how it may be used a criterion for determining whether to pursue an investment or project

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Answer #1

Profitability index can be defined as an index which arrives by dividing the the present value of future cash flows by the initial investment and the same has been shown as below:

= Present value of future cash flows / Initial investment

If the profitability index of a project is greater than 1, it implies that the present value of future cash flows is greater than the initial investment or in other words the NPV of a project is positive and hence the firm shall undertake the project.

If the profitability index of a project is less than 1, it implies that the present value of future cash flows is less than the initial investment or in other words the NPV of a project is negative and hence the firm shall not undertake the project.

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