A Business Encyclopedia

Profitability Index

Definition: The Profitability Index measures the present value of returns derived from per rupee invested. It shows the relationship between the benefits and cost of the project and therefore, it is also called as, Benefit-Cost Ratio.

The profitability Index helps in giving ranks to the projects on the basis of its value, the higher the value the top rank the project gets. Therefore, this method helps in the Capital Rationing.

The formula to calculate the Profitability Index is:

PI = Present value of future cash inflows/ Present value of cash outflows

Accept-Reject Criteria: The project is accepted when the value of PI exceeds 1. If the value is equal to 1, then the firm is indifferent towards the project and in case the value is less than 1 the proposal is rejected.

Merits of Profitability Index

  1. It takes into consideration, the Time Value of Money.
  2. The profits are considered throughout the life of the project.
  3. This method helps in giving the ranks to the projects.
  4. It helps in assessing the risk involved in cash inflows through the cost of capital.
  5. It also helps in assessing the increase or decrease in the firm’s value due to the investments.

Demerits of profitability Index

  1. Unlike the NPV, the Profitability Index may sometimes do not offer the correct decision with respect to the mutually exclusive projects.
  2. The cost of capital is must to compute this ratio.

It is a modernized version of Net Present Value that shows the present value of future cash inflows over the present value of cash outlay. Whereas the NPV shows the difference between the present value of future cash inflows and the present value of cash outlay. Also, the NPV is an absolute measure, whereas the Profitability Index is a relative measure.

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