Monday, February 15, 2010


NPV versus Profitability Index

The net present value (NPV) and profitability (PI) yield same accept or reject rules, because profitability index (PI) can be grater than one only when the project’s net present value is positive. In case of marginal projects, net present value (NPV) will be zero and profitability index (PI) will be equal to one. But a conflict may arise between the methods if a choice between mutually exclusive projects has to be made.

Consider the following illustration where the two methods give different ranking to the projects.

Project X

Present value of cash inflows 200000 $
Initial cash out flow 100000 $
NPV 100000 $
Profitability index 2

Project Y

Present value of cash inflows 100000 $
Initial cash out flow 40000 $
NPV 60000 $
Profitability index 2.5

Project X should be accepted if we use the NPV method, but project Y is preferable according to the profitability index (PI).

Which method is better?

The net present value (NPV) method should be preferred, except under capital rationing, because the NPV reflects the net increase in the firm’s wealth. In our illustration, project X contributes all that project Y contributes plus additional NPV of 40000$ (100000$ - 60000$) at an incremental cost of 100000$ (200000$ - 100000$). As the NPV of project X’s incremental outlay is positive, it should be accepted. Project X will also be acceptable if we calculate the incremental profitability index. This is shown as follows:

Because the incremental investment has a positive NPV, 40000$ and a profitability index (PI) grater than one, project X should be accepted.

If we consider a different situation where two mutually exclusive projects return 200000$ each in terms of NPV and one project costs twice as much as another, the profitability index (PI) will obviously give a logical answer. The net present value method will indicate that both are equally desirable in absolute terms. However, the profitability index (PI) will evaluate these two projects relatively and will give correct answer. Between two mutually exclusive projects will same NPV, the one with lower initial cost or higher PI will be selected.

1 comment:

Leslie Lim said...

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