PROFITABILITY INDEX (PI)
Profitability index (PI) is the present value of an investment’s future cash flows divided by its initial cost. Also, it is benefit-cost ratio.
PI = PV/I
PV: sum of present value of cash flows subsequent to initial cash flow
I: initial cash flow
Accept/Reject Decision:
- if PI>1=> accept the project
- if PI<1=> reject the project
Advantages of Profitability Index (PI) :
- Closely related to NPV, generally leading to identical decisions.
- Easy to understand and communicate.
- May be useful when available investment funds are limited.
Disadvantages of Profitability Index (PI):
It may lead to incorrect decisions in comparisons of mutually exclusive investments.
Example:
Investment A has the following cash flows:
If discount rate is 10 percent, is it good investment?
Solution:
PV=10,000/(1+0.1)1+1,000/(1+0.1)2+1,000/(1+0.1)3=10,669
Initial investment =10,000
PI=10,669/10,000=1.07 > 1. It means that $1 investment will return PV of $1.07, so this project should be taken.
Source:
- Phnom Penh HR
- Mcgraw-Hill – Fundamentals Of Corporate Finance