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Profitability Index Method

Profitability index Assignment / Homework Help
This is a refinement of the Net Present Value method. Instead of working out the net present value, a present value index is found. It can be put up in the form of the following formula:

Formula:

Profitability index = Present value of future cash inflows * 100
                              Present value of future cash outflows

Definition:

Profitability index is yet another time-adjusted method which measures the present value of returns per rupee invested. The profitability index is also called as Benefit-cost ratio or excess present value index. It may be defined as the ratio which is obtained by dividing the PV of the future cash inflows by the present value of cash outflows.

Accept/Reject Criterion:

Under this method, a project would be qualified to be accepted if its PI exceeds one. If PI equals one, the firm is indifferent to the project. If PI is lesser than one, the project would be rejected. When two or more projects are compared, the project which has the highest PI will be considered. This is because, higher the PI, greater is the profitability of the project.


Importance of PI in evaluation of projects:

Profitability Index method has got similar benefits like the Net Present value method.
  • It considers time value of money.
  • It takes into account the cash inflows and outflows throughout the economic life of the project.
  • The benefits of considering cash flows rather than accounting profit also applies to this method.
  • It is capable of handling any discount rate to determine the present value of cash flows to suit the prevailing market condition.
  • Though PI method is almost similar to NPV method and has got the same advantages, the former is still a better measure because PI measures the relative profitability and NPV, being an absolute measure.

Example:

Excess present value index provides ready comparison between investment proposals of different magnitudes. For example, Project A requiring an investment of $100,000 shows excess present value of $20,000 while another project B requiring an investment of $10,000 shows an excess present value of $5,000. If absolute figures of net present values are compared, project A may seem to be profitable. However, if excess present value index method is followed, project B would prove to be profitable.

Present value index for Project A = $120,000 / $100,000 * 100 = 120%
Present value index for Project B = $15,000 / $10,000 * 100 = 150%.