Profitability Index Meaning and Formula
Profitability Index Meaning – It is the ratio of present value of cash inflows to the initial cash outflows or initial investment.
PI or Profitability Index is another discounted cash flow method of capital budgeting. Just like Net Present Value (NPV) and IRR (internal rate of return), it is also one of the most sound method for appraising a project. It is calculated just like NPV and is a variation of it.
Profitability Index Method Features
- Time Value of Money – It takes into consideration Time Value of Money.
- Value Maximisation – It follows the shareholder’s wealth maximization principle. A project having PI greater than one has positive NPV. So, if the project is accepted it is result in increase in the wealth of shareholders.
- Relative measure – In PI method, the profitability of project is estimated by dividing the cash inflows with initial cash outflows. It is a relative measure of project’s profitability.
Profitability Index Formula
PI = PV of cash inflows / Initial cash outflows
Profitability Index Example
To understand the profitability index meaning in more better way, let’s discuss an example.
The initial cash outflow of a project is Rs. 1,00,000. Suppose it generate cash inflows of 50000, 40000, 30,000, 25000 in year 1 to 4. The discount rate is 10 percent. Calculate the present value of cash inflows at 10 percent discount rate.
PV = 50,000 PVF (1,10) + 40,000 PVF (2,10) + 30,000 PVF(3,10) + 25,000 PVF (4,10)
= 50,000 × 0.909 + 40,000 × 0.826 + 30,000 × 0.751 + 25,000 × 0.68
NPV = 45,450 + 33,040 + 22,530 + 17,000
= 1,18,020 – 1,00,000
= 18,020
PI = 1,18,020/1,00,000
= 1.1802
Acceptance rule for PI
The acceptance rule for project through PI is given below –
- PI>1, Accept project when project’s PI is greater than 1.
- PI<1, reject project when project’s PI is less than 1.
- If PI = 1, may or may not accept the project.
This implies that projects that have positive NPV has PI greater than 1 and vice versa.