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The Profitability Index (PI) is a financial tool that helps investors evaluate the profitability of an investment by comparing the present value of future cash flows to the initial investment. A PI greater than 1 indicates a profitable investment, while a PI less than 1 means the investment may not be worthwhile.
The formula to calculate the Profitability Index is:
Profitability Index (PI) = Present Value of Future Cash Flows / Initial Investment
For example, if the initial investment is $100,000, and the present value of future cash flows is $120,000, then the PI would be calculated as:
PI = $120,000 / $100,000 = 1.2
A PI of 1.2 means the investment is expected to generate a 20% return above the initial investment, making it a profitable investment.
Using a Profitability Index allows investors to assess the viability of an investment. It is particularly useful for comparing multiple investment options. The PI helps in identifying which projects have higher returns relative to the amount invested, making it a powerful tool for capital budgeting decisions.