Answer to Question #206332 in Management for Prince

Question

SUBJECT : PROJECT PLANNING AND CONTROL

1. Discuss the usage and application of Profitability Index method of capital Budgeting ? (please give at least 2 points for each usage and application )

Answer 1

The profitability index is a capital budgeting technique that determines the link between the cost of a proposed investment and the benefits that could be generated if the venture succeeds. The profitability index is calculated as a ratio of the present value of future cash flows divided by the initial investment. As this ratio rises above 1.0, corporations become more interested in the proposed investment. The investment should be deferred if this ratio does not exceed 1.0, as the project's present value is less than the initial investment. The downside of utilizing the profitability index for capital planning is that it doesn't take into account the scale of a project; as a result, large projects with large cash flow numbers generally have lower profitability indexes due to their smaller profit margins. The advantage of adopting the profitability index is that it takes into account the time worth of money when calculating returns. It also determines the precise rate of return for a project or investment, making the cost-benefit ratio of initiatives easier to comprehend.