Capital Budgeting

Session 14
Profitability Index
Profitability index

• The profitability index (PI) is a measure of a project's or

investment's attractiveness.

• The Profitability Index is calculated by dividing the present value of

future expected cash flows by the initial investment amount in the
project.

• A PI greater than 1.0 is deemed as a good investment, with higher

values corresponding to more attractive projects.
Importance of PI

• Profitability index, also known as profit investment ratio and value

investment ratio, is the ratio of payoff to investment of a proposed
project.

• It is a useful tool for ranking projects because it allows you to

quantify the amount of value created per unit of investment.

• PI greater than one indicates that present value of future cash

inflows from the investment is more than the initial investment,
thereby indicating that it will earn profits.
Advantages of using PI
• The profitability index indicates whether an investment would create or destroy
company value.

• It takes into consideration the time value of money and the risk of future cash
flows through the cost of capital.

• It is useful for ranking and choosing between projects when capital is rationed.

• It measures the ratio between the present value of future cash flows and the
initial investment. It presents a parallel between the costs and profits of a
certain project.

• It is an investment tool that is easy to understand.

• It ascertains the exact rate of return of the project.

• It will take into consideration all cash flows from a project.

Demerits of PI

• The information generated is based on estimates instead of

facts.
• The tool ignores what is called the “sunk cost.”
• It can be difficult to estimate opportunity costs.
• It is difficult to understand interest rate or discount rate.
• It is difficult to calculate profitability index if two projects
having different useful life.
Calculation of PI
• In order to determine which project to pursue, the best formula to use is the Present value
Index.

• PI may be computed using either of the following formulae:

• Formul a 1:

• PI = PV of inflows/PV of outflows.

• Formul a 2:

• PI = 1+ (Net Present Value / Initial Investment Required)

Interpretation
Example 1

• Calculate the Profitability index of the

project at 10% cost of capital

• Advice Jade Ltd. whether the project must

be accepted or rejected, based on the PI.
 Solution

Jade Ltd. may

accept the proposal
since PI is greater
than 1.
Question 1

• PQR Ltd. is considering an investment proposal costing $ 30,000.

Calculate the PI (using formula 2) and determine whether it is worth
investing at 10% cost of capital. The cash flows are are follows:
Solution

Year Cashflow (in ‘000 $) PV factor at 10% PV of Cashflow

1 5 0.909 4.545
2 10 0.826 8.260
3 15 0.751 11.265
4 20 0.683 13.66
5 25 0.621 15.525
Total 53.255

Investment = 30,000
NPV = 53,255 - 30,000 = 23,255

Profitability Index = 1 + (NPV/Initial Investment)

PI = 1 + (23,255/30,000)
PI = 1+0.77 = 1.77

The Project may be accepted owing to PI greater than 1.

Question 2

• From the following data, compute the number of dollars returned for
every dollar invested. Recommend which is the best investment
proposal.
Solution
Question 3

• Using the following information compute the PI of each project, identify

the best project to pursue and give reasons for your answer
Solution

• Project B may be chosen since it has a higher PI compared to Project A.

Question 4

• What is the profitability index for the following set of cashflows at a discount
rate of 10%. What would the PI be at 15% and 22% discount rate?

Year Cash flow (in $)

0 -27,500
1 15,800
2 13,600
3 8,300
Solution
• Calculating PI at 10%

Year Cash inflow PVF at 10% Discounted CF

1 15000 0.909 14362
2 13000 0.826 11233
3 8300 0.751 6233
Total 31,829

Profitability index = 31829/27500 = 1.16

Solution contd..
• Calculating PI at 15% • Calculating PI at 22%
Question 5
• Geremy Company invests in a new project. Their initial investment is the US
$10000. Calculate their PI at 10% discount rate. Given below is the cash inflow
for the next 5 years –
Solution

PI Formula = PV of Future Cash Flows / Initial Investment Required

Question 6

• Paint & Co. wishes to Invest in a new painting technology. Using the PI
method advice them about the decision to accept/reject the proposals. The
company provides the following cash flows, to be estimated at a 10%
discount rate for project A and at 12% discount rate for project B.
Year Cash flows (Project A) Cashflows (Project B)
0 (20,00,000) (30,00,000)
1 3,00,000 6,00,000
2 6,00,000 8,00,000
3 9,00,000 9,00,000
4 7,00,000 10,00,000
5 6,00,000 12,00,000
Solution

Year Cash flows (A) PV of Cashflows Cash flows (B) PV of Cashflows

at 10% (A) at 12% (B)
1 3,00,000 2,72,727 6,00,000 5,35,714
2 6,00,000 4,95,868 8,00,000 6,37,755
3 9,00,000 6,76,183 9,00,000 6,40,602
4 7,00,000 4,78,109 10,00,000 6,35,518
5 6,00,000 3,72,,553 12,00,000 680,912
Total 22,95,440 3,130,502

Profitability Index of Project A = 22,95,441 / 20,00,000 = 1.15

Profitability Index of Project B = 31,30,502 / 30,00,000 = 1.04

Using the formula of profitability index, it can be seen that Project A will create an additional value of
Re. 0.15 for every Re.1 invested in the project compared to Project B, which will create an additional
value of Re. 0.04 for every Re. 1 invested in the project. Therefore, Paint & Co. should select Project
A over Project B.