Question

*Min of 350 words*

Discuss the profitability index and describe how it is used in capital investment decisions.

Answer 1

Companies with the approach of investment uses various types of methods or indexes to predict the future outcome of their investments. They make certain investments after making proper analysis. These analysis are carried out using various tools.

One of the most reliable source of prediction in the use of profitability index in determining whether such an investment should be made or not.

Profitability Index(PI) is the index, which gives us the analysis about the investment which we are going to make. PI determines whether such investment is profitable or not.

While calculating the PI, the present value of future cash flows is calculated and then it is divided by the initial investment made.

OR

PI = P.V of future cash flows/initial investment.

Now, we get three types of Profitability Index (PI)

1. The first one, if PI is greater than zero (P>0) it means that the investment is profitable and a company should make such an investment or should select the investment if compared between two investments.
2. The second one, if PI is less than zero (PI<0), it means that investment is not at all profitable and the company should never make such an investment.
3. The third one, if PI is equals to zero (PI=0) it is that there is no profit no loss in such an investments.

Advantages of Profitability index

• helpful in comparing between the two investments.
• helpful in ranking between two projects.
• It takes into consideration the future value of money or you can say that the time value of money and the risk of future cash flows.

Disadvantages of Profitability index

• it require a lot of calculations.
• in certain cases it may not indicate the correct the decisions, where there is the initial investment difference.