Akash Pgdm-profitability Index

PROFITABILITY INDEX

DEFINITION  Profitability Index approach measures the present value of returns per rupee invested.  PI can be defined asPI=PV of cash inflows / PV of cash outflows Or PI=(NPV + Initial Investment) / Initial Investment  This method is also known as Benefit-Cost Ratio(B/C Ratio).

ACCEPT-REJECT RULE  PI > 1

The firm will accept the project.

 PI = 1

The firm is indifferent to the project.

 PI < 1

The firm will reject the project.

EVALUATION Example-1: a company invested Rs.20,000 for a project and expected NPV of that project is Rs.5,000. Profitability Index = (20,000 + 5,000) / 20,000 = 1.25 That means a company should perform the investment project because profitability index is greater than 1.

Example-2 : It is given that, • Investment = Rs.40,000 • life of the Machine = 5 Years Now, CFAT Year CFAT 1 18000 2 12000 3 10000 4 9000 5 6000

Continued….. NPV and PI at 10% : Year CFAT 1 18000 2 12000 3 10000 4 9000 5 6000

PV@10% PV 0.909 16362 0.827 9924 0.752 7520 0.683 6147 0.621 3726

Continued…. Now, Total present value = Rs. 43679 Investment = Rs. 40000 NPV = Rs. 3679 And, PI = 43679 / 40000 = 1.091 = >1 = Accept the project

NPV versus PI • In case of Accept Reject decision—Both are same • In case of evaluation of mutually exclusive proposals—PI is superior to NPV. ExampleProposal A Proposal B Cost Rs.1,00,000 Rs.80,000 PV of inflows Rs.1,20,000 Rs.1,00,000

NPV = PV of Inflows – Cost =Rs.20,000 PI = PV of Inflows / Cost PI(A) = 1.20 PI(B) = 1.25

• In case of Contradictory Decisions—NPV is superior to PI. ExampleProject A Project B Inetial outflows Rs. 1,50,000 Rs.1,10,000 PV of Inflows Rs.2,10,000 Rs.1,65,000 Now we have…………….. NPV Rs.60,000 Rs.55,000 PI 1.4 1.5