PROFITABILITY INDEX

Ernest Sudheer K Mohanty25

Karthik Ghanta 30
 PROFITABILITY INDEX
• Profitability Index is another time adjusted method
of evaluating the investment proposal.
• Profitability Index is the ratio of Present value of
cash inflows, at the required rate of return, to the
initial cash outflow of the investment.
• Formula:
PI = Present Value of cash inflows / Present Value of Cash
outflows
ACCEPTANCE RULE

The following are the PI acceptance rules:

• Accept the Project when PI is greater than 1 (PI>1)

• Reject the project when PI is lesser than 1 (PI<1)

• May accept the project when PI is equal to 1 (PI=1)

• PI is the variation of NPV method and requires the same
computations as NPV method.
• The project with positive NPV will have PI>1
• The project with negative NPV will have PI<1
• Time value of money:
• It recognizes the time value of money.
• Value Maximization:
• It is consistent with the share holder value maximization
principle.
• The project with PI>1 will have positive NPV and if
accepted, it will increase shareholders wealth.
• Relative Profitability:
• In PI method since the present value of cash inflows is
divided by initial cash outflow, it is a relative measure of
projects profitability.

• Like NPV method, PI also requires calculation of cash

flows and estimating of discount rate.
• In practice, estimation of cash flows and discount rate,
pose problems.
EXAMPLE:
• The initial cash outflow of a project is Rs
1,00,000 and it generates cash inflow of
Rs 40,000, Rs 30,000, Rs 50,000 and Rs
20,000 in year 1 through 4.
• Assume a 10 % rate of discount.
• What is the Profitability Index?
Year: Cash inflows: PV at 10%: Present Value:
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 20,000 0.683 13,660
. 1,12,350

Present Value of cash inflows = 1,12,350

Present Value of Cash outflows = 1,00,000
PI = 1,12,350/1,00,000
. = 1.1235

Since PI>1, project is accepted