Question

Could anyone explain why a Profitability Index may lead to inaccurate decisions when comparing mutually exclusive investments? Thanks

Answer 1

Formula:Profitability index (PI)=Present value of future cash flows /initial cash outflow

=1+(Net Present Value/ Initial Cash outflow)

1. Profitability index basically involves comparing your present value of cash inflows with your initial cash outflows.In other words , you are calculating the relative value for your investments in various projects.
2. As mentioned above in formula, Profitability index is closely related to Net present Value(NPV).
3. Its being used to compare the relative ratio as per formula above and decide whether to accept the project or reject the project.
4. We accept the project when PI>1 and Reject the project when PI <1
5. Usually the results are same as NPV decision for acceptance and rejection of projects but exception is in case of mutually exclusive project with different invesments.
6. When NPV>0( Positive),then PI>1- accept the project
7. When NPV<0( Negative) then PI<1- reject the project.
8. But in case of mutually exclusive project with different investments, PI based decisions does not indicate which project has shorter return duration and which project has longer return duration. In that case, NPV is better indicator. eg:

• a project A has cash inflow of 2000 and initial cash outflow of 1000 . So NPV=2000-1000=1000 and PI=2000/1000=2
• another project B has cash inflow of 1000 and cash outflow of 400 . NPV=1000-400=600 and PI=2.5
• Project A - accepted basis NPV and B accepted basis PI
• But PI is better method for capital rationing decision and A should be accepted as it adds to shareholder's wealth
• A-----adds all that is contributed by B i.e 600 plus it also adds 400 i.e positive value added with incremental cash outlay.Thus A preferred over B due to positive shareholders wealth in case of mutually exclusive project.