Under what circumstances will you prefer profitability index to NPV as project evaluation techniques

Expert Solution

PROFITABILITY INDEX

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), cost-benefit ratio or benefit-cost ratio.

Profitability index is used the time value of the money concepts in its calculation. Profitability index ratio is calculated, the present value of the future cash flows, divided by initial investment for the project. Different formulas are used for Profitability index calculation. The result of all formulas must be the same. You may use any one formula, selection of the formula depends on your requirement and available data of the projects.

Profitability index formula

Profitability index equal the present value of future cash flows divided by the initial investment.

The Advantages of Profitability Index are given below.

1. Profitability index considers the time value of money. 2. Profitability index considers the analysis of all cash flows of the entire life. 3. Profitability index makes the right in the case of the different amount of cash outlay of different project. 4. Profitability index ascertains the exact rate of return of the project.

The disadvantages Of Profitability Index are as follows:

1. It is difficult to understand the interest rate or discount rate. 2. It is difficult to calculate profitability index if two projects having a different useful life.

Accept/Reject criteria

If profitability index is greater than one (1) accept the project (investment)
If profitability index is less than one (1) reject the project (investment)

NPV (Net Present Value)

Net present value method is one of the modern methods for evaluating the project proposals. In this method cash inflows are considered with the time value of the money. Net present value describes as the summation of the present value of cash inflow and present value of cash outflow. Net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.

Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, it would be accepted.
If not, it would be rejected.

jeff jeffy answered 2 years ago

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