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Profitability Index (PI)

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The Profitability Index (PI), also known as the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR), is a capital budgeting tool used to rank investment projects and measure the value created per unit of investment. It is calculated by dividing the present value of future expected cash flows by the initial investment cost. A PI greater than 1 indicates that the project's net present value (NPV) is positive, suggesting that it is likely to be profitableIn financial analysis and feasibility studies, the Profitability Index helps in comparing and selecting projects when capital is limited. It provides a relative measure of profitability, allowing analysts to prioritize projects that offer the highest returns per dollar invested. For example, if Project A has a PI of 1.3 and Project B has a PI of 1.5, Project B is considered more attractive as it generates $1.50 for every $1 invested, compared to $1.30 for Project AThe PI is particularly useful when evaluating multiple projects with different scales of investment and cash flows. It assists in resource allocation by identifying projects that maximize value creation and align with strategic objectives. By focusing on the efficiency of capital usage, the PI ensures that limited resources are invested in the most beneficial projectsHowever, relying solely on the Profitability Index has limitations. It does not consider the total amount of value created; a project with a high PI but small absolute cash flows might be less desirable than a project with a lower PI but significantly higher cash flows. Therefore, the PI should be used in conjunction with other financial metrics, such as NPV and Internal Rate of Return (IRR), to obtain a comprehensive view of a project's financial attractivenessIn summary, the Profitability Index is a valuable tool in financial analysis for assessing investment efficiency and guiding decision-making under capital constraints. It aids in selecting projects that offer the best return per unit of investment, thereby contributing to optimal capital budgeting and strategic planning.

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Question 1

In project selection using Profitability Index (PI), what action should be taken when a project has a PI value between 0.8 and 0.9?

Correct Answer: Reject the project as it indicates negative return on investment

In project selection, the Profitability Index (PI) measures the ratio of present value of future cash flows to the initial investment. A PI value of 1.0 is the breakeven point. When PI is less than 1.0, it indicates that the present value of future cash flows is less than the initial investment cost. A PI between 0.8 and 0.9 shows that the project will return only 80-90% of the invested capital, resulting in a loss. This makes accepting such a project financially unsound. The correct answer is to reject the project as it indicates negative return on investment. The other answers are incorrect because: - A PI below 1.0 never indicates potential for break-even - PI values below 1.0 do not indicate minimal investment risk; they actually indicate guaranteed losses - Future cash flows would be negative in present value terms, so further evaluation would be unnecessary and wasteful of resources.

Question 2

In project portfolio analysis, when comparing two projects with identical Net Present Values (NPV), what does a higher Profitability Index (PI) typically indicate?

Correct Answer: The project requires less initial capital investment to achieve the same NPV

The Profitability Index (PI) is calculated by dividing the present value of future cash flows by the initial investment. When two projects have identical NPVs, a higher PI indicates that one project achieves the same NPV with a smaller initial investment. This is significant because: - It shows better capital efficiency - It indicates lower upfront resource requirements - It suggests better return per dollar invested The other options are incorrect because: - Long-term sustainability and operational efficiency are not measured by PI - Consistency of cash flows is related to risk assessment, not PI calculations - Strategic alignment and stakeholder expectations are not measured through PI PI specifically measures the present value of future cash flows per unit of investment, making it an excellent tool for comparing capital efficiency between projects with equal NPVs.

Question 3

When evaluating multiple projects with different Profitability Indices (PI), which of the following statements is most accurate?

Correct Answer: Projects with PI > 1 create value, and higher PI values indicate better investment opportunities

Profitability Index (PI) is a valuable metric for evaluating investment opportunities, where: Key points about PI: - PI = Present Value of Future Cash Flows / Initial Investment - PI measures value created per unit of investment - A PI greater than 1 indicates the project creates value - Higher PI values indicate greater returns relative to investment The correct answer accurately states two critical aspects of PI: 1. Projects with PI > 1 create value (as benefits exceed costs) 2. Higher PI values indicate better investment opportunities (more value per unit invested) Why other options are incorrect: - PI = 1 only indicates break-even, not maximum value - Lower PI values actually indicate less value creation, not more stability - PI values are crucial for project selection as they measure relative value creation For business analysts, understanding PI helps in making data-driven investment recommendations and prioritizing projects effectively.

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