Concept And Meaning Of Profitability Index (PI)
The profitability index is known as benefit cost ratio. PI is similar to the NPV approach. The profitability index approach measures the present value of return per dollar invested, while the NPV is based on the difference between the present value of the future cash inflow and present value of cash outlay. PI is calculated by dividing the present value of future cash inflow by present value of cash outlay.
Profitability Index (PI) = Total present value/Net cash outlay
Profitability Index (PI) = Total present value/Net cash outlay
Calculation Of Profitability Index (PI)
Illustration
The cash flow of two projects are as under:
Years.......................0................1...................2......................3...................4
Project A..........-25000..........8000..........8000................8000............8000
Project B..........-25000..........10000........11000...............8000............5000
The cost of capital is 10%
Required:
Calculate PI Of each project
Solution,
Project A.
Total present value = Annual cash flow x 10% annuity factor = 8000 x 3.170 = $ 25,360
Profitability Index (PI) = TPV/NCO = 25,360/25,000 = 1.01
Project B,
Year............................CFAT.........................10% Factor.........................PV
1..................................10000.......................0.909.................................9090
2..................................11000........................0.826.................................9086
3...................................8000..........................0.751..................................6008
4...................................5000..........................0.683..................................3415
Total present value(TPV).......................................................................27,599
Profitability Index (PI) = TPV/NCO = 27599/25000 = 1.10
Decision Rules Of Profitability Index(PI)
A. If projects are independent
Accept the project when PI is higher than 1.
Reject the project when PI is less than 1.
Accept the project when PI is higher than 1.
Reject the project when PI is less than 1.
B. If projects are mutually exclusive
Accept the project which has higher PI.(PI must be greater than one)
Reject other project.
In above calculation, project B should be selected because it has higher PI.
Accept the project which has higher PI.(PI must be greater than one)
Reject other project.
In above calculation, project B should be selected because it has higher PI.