Question

Profitability Index

Per the strict observance of the rules of Profitability Index, this project would be accepted because it meets the definition of >1. But as your pointed out, there are other considerations to factor into this decision. Most business decisions have a basis in financial support - or reason for undertaking a project. But there are non-quantitative reasons for undertaking or not undertaking a project...

Class

What are some non-financial reasons for undertaking a project that has a Profitability Index of less than 1?

Also, what are some non-financial reasons for not undertaking a project that has a Profitability Index of greater than 1?

Answer 1

Profitability index (PI) - It is one of the capital decision techiques. It is calculated as dividing the future cash flows by the initial investments.

If it is greater than one then it hould be taken as future cash flow will exceed the initial investment.

The reason for taking it, apart from financial data, is that it is easy to understand and comprehend. One would not need a financial expert in interpreting this decision. It is very basic in nature as we compare benefits against the costs and if the benefits increases it should be adopted.

The reason for not taking it, apart from financial data, is that it does not accounted for time value of money. It compares two different cash flows on the same time which is not good. In this way, it is not considering the riskiness of the cash flows. Also, it does not take into consideration cash flows after recovering the initial cash flows. The investment may subsequenly become ineffective if it is not been considered.