Wednesday, January 27, 2010


Profitability Index

Profitability index is the ration of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. Profitability index is another time adjusted method of evaluating the investment proposals is the benefit-cost (B/C) ratio or profitability index (PI).

PI = Present value of cash inflows/ Initial cash outflow

Acceptance Rule

The following are the profitability index (PI) acceptance rules:
  • Accept the project when profitability index is grater than one
  • Rejected the project when profitability index is less than one
  • May accept the project when profitability index equal one

The project with positive net present value will have profitability index grater than one. Profitability index less than one means that the project’s net present value is negative
Evaluation of profitability index (PI) method

Profitability index (PI) is a conceptually sound method of appraising investment projects. It is a variation of the net present value (NPV) method, and requires the same computations as the net present value (NPV) method.

  • Time value. It recognizes the time value of money.
  • Value maximization. It is consistent with the shareholder value maximization principle. A project with profitability index grater than one will have positive net present value (NPV) and if accepted, it will increase shareholders wealth.
  • Relative profitability. In the profitability index (PI) method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project’s profitability.

Like the net present value (NPV) method, this criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

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