2. Profitability Index
Profitability
Index (PI) is a capital budgeting
technique to evaluate the investment projects for their
profitability. Discounted cash flow technique is used
in arriving at the profitability index. It is also known as
benefit-cost ratio. Calculation of profitability index is
possible with a simple formula with inputs as –
discount rate, cash inflows and outflows. PI greater
than or equal to 1 is interpreted as good and is
acceptable.
3. Definition of PI
Profitability Index is a ratio of discounted cash inflow
to the discounted cash outflow. Discounted cash
inflow is our benefit in the project and the initial
investment is our cost, which is why we also call it
benefit to cost ratio
4. How to calculate the Profitability Index ?
The calculation of PI is easily possible once we have
the cash inflows and outflows with appropriate
discount rate are in place.
PI = Present Value of Future Cash Flows
Initial Investment Required
5. Example :
Cash outflow= 2,00,000
Cash flows: 40,000 , 30,000 , 50,000 & 20,000 through year 1,2,3&4 @
discount rate of 10%
Sol:
PI = 40000(PV1, .10)+30000(PV2, .10)+50000(PV3, .10)+20000(PV4, .10)
200000
PI = 40000(.909)+30000(.826)+50000(.751)+20000(.683)
200000
PI= 36360+24780+37550+13660
200000
PI = 1.1235
i.e., Project should be accepted
