Difference between Net Present Value (NPV) and Profitability Index (PI)

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The Profitability Index (PI) shows a parallel between the expenses and profits of a certain project. It is obtained by dividing the net present value of the property’s future cash flows by the initial investment.

  • When the profitability index is over 1.0, it is positive and the investment will generate profits.

  • If the PI is less than 1.0, then it is negative where the investment will probably fail.

In other words, the profitability index is the ratio between the net present value of future cash flows and the initial investment.

A profitability index number of 1.0 is likely the lowest desired number for investors. If PI is less than 1.0, it shows that the net present value is lower than the initial investment. Therefore, the project should probably be discarded.

  • Actually, both NPV and PI measures consider an investment property’s future cash flow. However, the net present value gives the dollar difference, while the profitability index is a ratio.

  • PI is an absolute value because it is a ratio. It represents the proportion of dollars returned to dollars invested without offering a specific amount. The profitability index allows the investors to compare the profitability of two properties irrespective of the amount of money invested in each.

  • The profitability index shows the value to be obtained by investing in a project. The PI is an alternative to the net present value (NPV). The Profitability Index becomes greater than 1.0 when the net present value appears positive. Otherwise, PI would be negative.

NPV and PI are often referred to as being similar.However, there is a difference between these two terms. The difference is that the profitability index does not suggest the amount of the actual cash flows.

NPV Discount Rate

While calculating NPV, a proper discount rate must be used. Generally, the return rate on unconventional investments or the weighted average cost of capital (WACC) is used.

When the NPV is lower, the discount rate will be higher. Investments with higher risk have a higher discount rate.

NPV for single investment can be calculated using the following formula −

𝐍𝐞𝐭 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 = 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 − 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Whereas for multiple investments

$$\mathrm{Net\:Present\:Value =\frac{Cash \:Flow}{(1 + 𝑟)𝑡}}$$

Where, indicates the discount rate and is the time of the cash flow.

Conclusion

NPV is the most successful and reliable method of investment evaluation, compared to other methods such as the payback period, the rate of return, internal rate of return (and Profitability Index). In fact, the profitability index is related to NPV, where the NPV presents an absolute measure, and the PI presents a relative measure.

raja
Updated on 28-Oct-2021 12:21:47

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