ACCA Financial Management (F9) Certification Practice Exam

How is the Profitability Index calculated?

1. Net Present Value divided by total investment costs

2. Present Value divided by the cost of investment required

3. The total profit over the asset's lifetime

4. Costs associated with long-term investments

The correct answer is: Present Value divided by the cost of investment required

The Profitability Index (PI) is a vital financial metric used in capital budgeting and investment decision-making. It is calculated by taking the Present Value (PV) of future cash flows generated from an investment and dividing it by the initial cost of the investment required. This ratio provides insight into the value gained per unit of investment, making it easier for decision-makers to assess the potential profitability of different projects or investments. When the PI is greater than 1, it indicates that the present value of future cash flows exceeds the initial investment, suggesting a potentially worthwhile investment. Conversely, a PI of less than 1 suggests that the investment may not be favorable. Therefore, this calculation is crucial for determining which projects to pursue when capital is limited. In this case, the choice that states the calculation of the Profitability Index involves Present Value divided by the cost of investment accurately describes the methodology used to derive the index and is the correct answer.