What Does a Profitability Index of .85 Indicate? | CTFA Exam Answer

C

A profitability index (PI) is a ratio that measures the present value of future cash flows from a project relative to the initial investment. A PI of 1 indicates that the project's present value of cash inflows is equal to the initial investment, while a PI greater than 1 indicates that the project is expected to generate positive net present value. Conversely, a PI less than 1 indicates that the project's cash inflows are not sufficient to cover the initial investment.

With this in mind, let's examine each answer choice to determine which one is correct:

A. The present value of benefits is 85% greater than the project's costs.

This answer choice is incorrect. A PI of .85 means that the present value of the project's expected cash inflows is 85% of the initial investment, not 85% greater than the project's costs.

B. The project's NPV is greater than zero.

This answer choice is also incorrect. While a PI greater than 1 indicates a positive NPV, a PI of .85 does not necessarily indicate that the project's NPV is greater than zero.

C. The project returns 85 cents in present value for each current dollar invested.

This answer choice is correct. A PI of .85 means that for every dollar invested in the project, the expected present value of future cash inflows is 85 cents. In other words, the project is expected to generate less cash inflows than the initial investment.

D. The payback period is less than one year.

This answer choice is also incorrect. The payback period measures the time it takes for the project's cash inflows to cover the initial investment. A PI of .85 does not provide enough information to determine the payback period.

Therefore, the correct answer is C: The project returns 85 cents in present value for each current dollar invested.