Question

What is the Profitability Index and what does it tell about a project or investment?  How is it calculated?

Answer 1

Just as we know the net present value method it helps us take decision on the basis of present value figures –

i.e. NPV = present value of cash inflows – present value of cash outflows.

If the outcome is positive we accept the project, if its negative we reject the project and if the outcome is zero we are indifferent in our decision.

Similarly the profitability index gives us index on the basis of present value of inflows net of present value of outflows. It is helpful in taking decision for a project as it gives ranking to the project and quantifies the value created by per unit of investment.

Profitability index can be calculated as under -

Profitability index (PI) = PV of future cash flows / present value of outflows (or initial investment)

Rules for acceptance of project –

Profitability index > 1                 accept the project

Profitability index < 1                reject the project

Profitability index = 1                indifferent in decision