Manag., July-2018 – Q7

0. Indicate the correct code from the following that does not represent the Profitability Index for an investment proposal of a firm:
(a) Average annual net income earned divided by the investment
(b) Equating annual net cash inflows to investment
(c) Ratio of present value of future cash inflows to investment making it equal to zero
(d) Ratio of present value of future cash inflows to present cash outflows

Answer
Comment
Array

Option : A
Explanation : Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.
Formula:
(a) Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
(b) Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Decision Rule
- Accept a project if the profitability index is greater than 1,
- Stay indifferent if the profitability index is 1,
- Don’t accept a project if the profitability index is below 1.

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