The Profitability Index (PI) is calculated by dividing the present value of future cash inflows by the initial investment. A PI greater than one indicates a profitable investment, with higher values reflecting more attractive opportunities.
Consider GreenTech Solutions, a renewable energy company evaluating two projects. Project X requires a $900,000 investment in a solar power plant, expected to generate cash flows with a present value of $1.2 million. Project Y, on the other hand, requires a $300,000 investment in wind turbines, with expected cash flows having a present value of $500,000. Using the PI formula, Project X has a PI of 1.33, while Project Y has a significantly higher PI of 1.67.
Given its limited capital, GreenTech Solutions might prioritize Project Y over Project X, as it offers a much higher return relative to its cost.
However, using the Profitability Index alongside other financial metrics such as Net Present Value (NPV) or Internal Rate of Return (IRR) would provide a more comprehensive evaluation of the projects' potential.
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