**Limitations of Profitability Index**

The capital budgeting procedure described above does not always work. It fails in two situations:

**Multi-period capital constraints****Project indivisibility**

**Multi-period constraints**

The serious limitation in using the PI rule is caused by the multi-period constraints. In the above post example, there is a budget limit of 50000$ year 1 also and the firm is anticipating an investment opportunity 0 as in low is year 1. Thus, the decision choices today are as follows:

Project M and N have the first and second ranks in terms of PI. They together have highest NPV and also exhaust the budget in year 0; so the firm would choose them. Further, projects M and N together are expected to generate 20000$ cash flow next year. This amount with the next year’s budget (i.e. 20000$ + 50000$ = 70000$) is not sufficient to accept project O. Thus, by accepting M and N, the firm will obtain a total NPV of 15870$. However, a careful examination of the project’s cash flows reveals that if project L is accepted now it is expected to generate a cash flow of 30000$ after a year, which together with the budget of 50000$ is sufficient to undertake project O next year. Projects L and O have lower PI ranks than projects M and N, but they have higher total NPV of 19820$.

**Project indivisibility**

Suppose that the firm has budget ceiling of 10$ million. Following the ranking by PI, the firm would choose A and C. These projects spend 850000$ of the total a budget and have a total NPV of 180000$. The next best project E needs an investment of 200000$, while the firm has only 150000$. If we examine the various combinations of projects satisfying the budget limit, we find the package of C, E and D as the best. They exhaust the entire budget and have a total NPV of 189000$. Thus, the firm can choose two lower ranked, small projects, E and D, in place of the higher ranked, large project, A. This section procedure will become very unwieldy if the firm has chosen the best package of projects from a large number of profitable projects.

- Our discussion has shown that the profitability index can be used to choose projects under simple, one-period, capital constraint situation. It breaks down in the case of multi-period capital constraints. It will also not work when any other constraint is imposed, or when mutually exclusive projects, or dependent projects are being considered.

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