Question

Why is the profitablity index bad for valuing mutually exclusive projects, and why would NPV be a better valuation method?

Answer 1

Ans:

Profitability index is a tool to evalute a project whether it should be selected or not. If PI is greater than 1 project should be selected whereas less than 1 project should be rejected. Here 1 shows breakeven position.

NPV is discounted cashflow for project selection. In NPV positive NPV means project should be selected and Negative NPV means project should be rejected.

When NPV of project is positive then PI is also more than 1 and when NPV is negative then PI is less than 1.

Only difference between them is PI is a ratio showing more than 1 or less than 1 it does not show actual cashflow size in project. It is possible that project is more than 1 but initial expenditure is very high that ultimately project will generate very low profit or breakeven position. This is the reason it is bad for project selection.

NPV method uses present value factor to get present value of cashflow for the project and finally initial investment is deducted to get real valuation. It considers time value of money and cash flow present value. This is the reason NPV is better valuation tool.