Profitability Index (PI) is a capital budgeting technique to evaluate the investment projects for their viability or profitability. Discounted cash flow technique is used in arriving at the profitability index. It is also known as a benefit-cost ratio. Calculation of profitability index is possible with a simple formula with inputs as – discount rate, cash inflows, and outflows. PI greater than or equal to 1 is interpreted as a good and acceptable criterion.
Profitability Index Definition
Table of Contents
- 1 Profitability Index Definition
- 2 Profitability Index – Advantages and Disadvantages
Profitability Index is a ratio of discounted cash inflow to the discounted cash outflow. Discounted cash inflow is our benefit in the project and the initial investment is our cost, which is why we also call it benefit to cost ratio.
Profitability Index Method
The method used for arriving at profitability index of a proposed project is explained stepwise below:
a) Find the expected cash inflows of the project
b) Find the cash outflows of the project (Initial Investment + any other cash outflow)
c) Decide an appropriate discount rate
d) Discount the expected cash inflows using the discount rate
e) Discount the future cash outflows and add to initial investment
f) Divide step (d) by step (e)
How to calculate the Profitability Index
The calculation of PI is easily possible once we have the cash inflows and outflows with appropriate discount rate are in place.
Profitability Index Formula
The formula indicates the benefits in the numerator and costs in the denominator. The formula for calculating Profitability Index is as follows:
Example of Profitability Index (PI)
Let’s assume the cash flows of a project as mentioned year wise in the second column of the below table. The negative cash flows are the costs and positive ones are the benefits. In the third column, they are discounted at 10% rate. All the discounted benefits are added to make $ 16,832 and discounted costs to make $15,450.
|(CF)||CF @ 10%|
The benefit to cost ratio or the PI can be found out by dividing benefits by costs (16832/15450 = 1.382)
Acceptance Criteria or Interpretation
A profitability index of anything equal to or greater than 1 is considered good. It means that the project is worth executing. PI greater than 1 indicates that the project is paying something more than the required rate of return of the investor. In our example, the project should be accepted as it is greater than 1 i.e. 1.09.
Profitability Index (PI) and Net Present Value (NPV)
Profitability Index is closely linked with net present value. Both will present same results as far as acceptance and rejection are concerned. It is because the almost same calculation is followed in both. In PI, we divide our benefits by our costs whereas, in NPV, we deduct our costs from the benefits. PI will give a relative value and contrarily
Profitability Index – Advantages and Disadvantages
The advantage of profitability method is that it considers the time value of money and presents a relative profitability of the project. Relative profitability allows comparison of two investments irrespective of their amount of investment. A higher PI would indicate a better IRR and a lower PI would have lower IRR.
The main disadvantage of the PI method is also its relative indications. Two projects having the vast difference in investment and dollar return can have the same PI. In such situation, therefore, the NPV method remains the best method.