5th Semester : Financial Management Capital Budgeting

Session: 049
PROFITABILITY INDEX METHOD
PROFITABILITY INDEX METHOD / PRESENT VALUE INDEX METHOD /
BENEFIT – COST RATIO METHOD
This method is an improvement over the net present value method, as it provides a relative
measure for comparing projects of different magnitudes.

Under this method, instead of finding out the net present value of each of the investment
proposals, a present value index is made out for each of the proposal.

“The present value index or present value profitability index or benefit cost ratio is the
relationship between the total or gross present value of the cash inflows and the total
cash outflows.”

This method expresses a mathematical relationship between the initial outlay and that of
total discounted cash inflows.

The profitability index (PI) is the ratio of the present value of change in operating cash
inflows to the present value of investment cash outflows.

The present value index can either be expresses as a co-efficient or as a percentage also.

The PI signifies present value of inflow per rupee of outflow. It helps to compare projects
involving different amounts of initial investments.

Features of Profitability Index Method

1. Ascertainment of present value of cash flows:

Under this method we need to ascertain the present value of cash inflows to be received
in different years from the project by applying a present value factor or a discounting
factor.

“For the purpose of Profitability Index Method, the cash flows mean the cash flows
or profits after tax but before depreciation.”

2. Decision rule/ Accept or Reject criteria:

Under this method, the selection is based on the present value index of each project.

‘In case of an independent project, if the Present value index is more than one the
project will be selected and otherwise it will be rejected.’

Digital Learning – DCE Kuvempu University, Shivamogga Page 1

5th Semester : Financial Management Capital Budgeting

‘In case of mutually exclusive projects, the project with higher Present value Index is
selected, and the projects with lower PI will be rejected.’

3. Time value of money is considered:

Profitability Index Method is one of the modern methods or discounting methods
which considers the time value of money while calculating cash flows from the project.
This method does recognise the fact that money received at future date is worth less
than the money received toady.

4. Earnings over the life of asset is considered:

This method considers the entire economic life of the project. This method takes into
account all the earnings generated by the project throughout its economic life and the
same will be discounted to the present value.

Merits of Profitability Index Method

1. This method is easy to understand and operate.

2. This method is an improvement over NPV method and is very much useful in ranking the
projects especially when the cost of projects differs significantly.

3. This method considers the time value of money as it reduces the future cash inflows to
the present value by discounting them. Hence provides a very good basis for decision
making.

4. This method considers the cash flows generated throughout the life of the asset or a
project.

5. This method is more scientific and reliable as it brings discounting concept into the
calculation of present value of cash flows and the money’s worth is valued at the
present date and at present value and not as they going to be at a future date.

Digital Learning – DCE Kuvempu University, Shivamogga Page 2

5th Semester : Financial Management Capital Budgeting

Demerits of Profitability Index Method

1. Compared to the traditional methods this method is more difficult to understand and to
operate.

2. It is not that much easy to determine an appropriate discount rate. And this method
consumes more time than other methods.

Calculation of Profitability Index Method (PI)

Steps in calculating IRR

I. Determining the present value of cash inflows of a project (after tax but
before depreciation)
II. Determining the relationship between initial outlay and total discounted
cash inflows

❖ Determination of PI

Profitability index can be expressed in different ways,

A. As a co -efficient, it is expressed as below

𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔

𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 =
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔

B. As a percentage, it is expressed as follows,

𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔

𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 = × 𝟏𝟎𝟎
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔

❖ Accept or Reject criteria

✓ If the PI is > 1 OR > 100 % the project is accepted

✓ If the PI is < 1 OR < 100 % the project is rejected

Digital Learning – DCE Kuvempu University, Shivamogga Page 3

5th Semester : Financial Management Capital Budgeting

Reference
• Dr. S.N. Maheshwari, Elements Of Financial Management,

• Prasanna Chandra, Financial Management

• V Rajeshkumar and Y Nagaraju, Financial Management

• Lakshmeesha and Akshatha M, Financial Management

• Shahsi k Gupta and R K Sharma, Financial Management Kalyani Publishers

• B S Raman, Financial Management , united publishers

• www.icmai.in

• www.icai.org

Digital Learning – DCE Kuvempu University, Shivamogga Page 4