Meaning of Profitability Index
- Also known as the Value Investment Ratio or Profit Investment Ratio, the Profitability Index represents the relationship between the costs and the benefits of a proposed project.
- It is also known as the benefit – cost ratio.
- It is also calculated as the ratio between the present value of future expected cash flow and the initial amount invested in the project.
- It is an appraisal technique that is applied to potential capital outlays.
Components of the Index
- It is calculated as the present value of future cash flows/ initial investment.
- The numerator will discount an appropriate number of periods to equate future cash flows to current monetary levels.
- The denominator represents the projected cash outflows representing the initial capital outlay of a project.
Interpreting the Index
- The higher the PI, the more attractive the project. If the value is greater than 1 then, it is considered a good investment.
- If the PI is equal to one, then, the project breaks even and the company is indifferent between proceeding or deciding to not proceed with the project.
- These values will not be in negative numbers and are usually positive.
- But one drawback of the same is that, the technique disregards the project size. For instance, Projects with greater cash inflows may result in lower profitability index calculations as the profit margins might not be that high.
- Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted.
Advantages of PI
- It indicates whether a particular investment creates value or not.
- It considers both the time value of money and the risk of future cash flows through the cost of capital.
- It can be used to choose between numerous projects for allocation of capital.
Disadvantages of PI
- It can only be calculated if there is an estimate of the cost of capital.
- In case of mutually exclusive projects, this index might not indicate the correct decision.
