Profitability Index (PI) Detailed Analysis, What is profitability index? Formula of Profitability Index, When we are thinking of investing into a particular project, we should always calculate the future possible cash inflows. Once the cash flows estimation is done, we should calculate its present value, that is, we should give due consideration to the time value of money. Once we are ready with the present value of cash inflows & outflows, we should make various analysis from them to understand their feasibility. One of such analysis is the Profitability Index. Let us have a look on how this ratio is calculated & used.
The profitability index is sometimes also called the cost-benefit ratio. The profitability index is the present value of anticipated future cash flows divided by the initial outlay for a particular project. The only difference between the Net present value method and profitability index method is that when we are using the NPV technique, the initial outlay is deducted from the present value of anticipated cash flows, whereas for the profitability index approach, the initial outlay for the project is used as the divisor.
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Mathematically, PI (profitability index) can be expressed as follows:
Profitability Index = Present Value of Cash Inflows/ Present Value of Cash Outflows
This method is also called cost benefit ratio or desirability ratio method.Let us understand this with the help of an example:
Eg. Consider the following two mutually exclusive projects:
|Initial Cash Outflow
|Present Value of Cash Inflows
|= 150000 / 100000
|= 50000 / 100000
In the given case, as project A has profitability-index greater than 1, it is acceptable whereas if we look at Project B, The Profitability-Index is less than 1, which clearly indicates that the Project B is unacceptable.
In the above case, both NPV method & PI method will give the same result. However, there may be some cases where both these methods may give different results.
Although PI method is based on NPV, it is a better evaluation technique than NPV in a situation of capital rationing. For example, two projects may have the same NPV of Rs. 10,000 but Project A requires initial outlay of Rs. 1,00,000 whereas B only Rs. 50,000. In such a case, Project B would be preferred as per the yardstick of PI method.
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In general terms, a project is acceptable if its profitability-index value is more than 1. This clearly indicates that the project offering a profitability index greater than 1 must also offer a net present value that is positive.
If the PI is 0, this will indicate that the present value of cash inflows is equivalent to the present value of cash outflows. In such a case, the decision to accept or reject a particular project will be based on the management policies of the company. Generally, in such cases, the project is accepted by the companies.