PROFITABILITY INDEX (PI)

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:

1. Phnom Penh HR
2. Mcgraw-Hill – Fundamentals Of Corporate Finance