Final answer:
The Profitability Index (PI) is a financial metric calculated by dividing the present value of future cash flows by the initial investment cost, used to determine the relative profitability of an investment.
Step-by-step explanation:
The Profitability Index (PI), which is also called the cost/benefit ratio or present value index, is a technique used to measure the relative profitability of an investment. It is calculated by dividing the present value of future cash flows by the initial investment cost. Essentially, the PI helps in comparing the present discounted value of future benefits with the present costs incurred. Whenever businesses or governments need to weigh the immediate costs of an action against its long-term benefits, using present discounted value is essential.
To calculate PI specifically, you would use the formula:
PI = Present Value of Future Cash Flows / Initial Investment Cost
If the PI is greater than 1, the investment is considered profitable because it indicates that the present value of future cash flows exceeds the initial costs. A PI of less than 1 implies that the investment would not cover its initial costs. This financial metric is a critical analytical tool not only in finance but also in environmental policy analysis, government proposals for public projects, and even for individual financial decisions such as lottery winnings.