Question

Brief literature review on profitability index and includes its merits and demerits

Answer 1

Profitbality Index is the ratio of Present value of Cash Inflows generated over the lifetime of the project over the present value of Cash Outflows associated, both being discounted at firms cost of capital or required rate of return. Mathematically

Profitability Index = PVCI / PVCO

For example

		A	B
	CI	5000	8000
	n	5	5
	discount Rate	8%	8%
	PVCI	$         19,964	$         31,942
Less	PVCO	$       (15,000)	$        (26,978)
	NPV	$           4,964	$            4,964
	Profitability Index (PVCI/PVCO)	1.33	1.18

The NPV of both project are same, but in Project it require $ 15000 to generate a NPV or 4964, but in case of Project B amount needed is 26,978. Thus Project A should be accepted, The PI of Projet A is higher and it shows the same result.

Merits of PI

1. It is based on Cash flows and not accounting profits.

2. Shows a relative return and thus very useful in case of capital rationing.

3. COnsiders time value of money.

Demerits

1. The cost of capital is pre requisite,

2, Didnt show how much wealth be added by accepting the project