Certified Management Accountant Practice Exam

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How is the profitability index calculated?

Net investment divided by the PV of future cash flows
Net profit divided by total investment costs
PV of future cash flows divided by net investment
Future cash flows divided by current liabilities

The correct answer is: PV of future cash flows divided by net investment

The profitability index is a financial metric used to evaluate the attractiveness of an investment by comparing the present value of future cash flows to the initial investment. To calculate the profitability index, you take the present value of future cash flows generated by the investment and divide that amount by the net investment or initial cost of the investment. This relationship indicates how much value is expected for each unit of currency invested. A profitability index greater than 1 suggests that the investment is likely to generate value and is considered favorable, as the present value of cash inflows exceeds the costs. This index effectively helps in prioritizing projects when capital is limited, allowing management to focus on those that will yield the greatest returns relative to their costs. The other calculations mentioned are related to different financial metrics and do not accurately represent the definition or the calculation method of the profitability index. Therefore, the correct understanding of the profitability index hinges on the ratio of the present value of future cash flows to the net investment.