- Trending Categories
- Data Structure
- Networking
- RDBMS
- Operating System
- Java
- iOS
- HTML
- CSS
- Android
- Python
- C Programming
- C++
- C#
- MongoDB
- MySQL
- Javascript
- PHP

- Selected Reading
- UPSC IAS Exams Notes
- Developer's Best Practices
- Questions and Answers
- Effective Resume Writing
- HR Interview Questions
- Computer Glossary
- Who is Who

Profitability Index (or PI) is a method to evaluate the profitability of investment projects. It is actually a benefit to cost ratio or the ratio of the present value of cash inflows at the required rate of return to the initial cash outflows of the investment.

Like NPV and IRR, PI is also a popular investment evaluation technique. However, the measurement procedure and application of the method have some differences in comparison to IRR and NPV. PI is a variation of the NPV method and requires similar computations as the NPV method.

Like IRR and NPV, PI also has some merits and demerits.

Following are the benefits of using the Profitability Index Method in evaluating the profitability of an investment −

Like NPV, PI also considers the time value of money. This leads to better recognition of profitability as the future incomes are taken to be less than the equivalent present incomes. By taking the time value of money into consideration, PI maximizes the true profitability of an investment proposal.

Time value of money also helps in determining the long-term goals as well as capital budgeting measures that require sound policies about future cash flows.

The PI process is consistent with the shareholders’ value maximization principle. The projects that have positive PI values that are more than 1 will have positive NPVs. According to the rules of thumb, projects with positive NPV are undertaken by firms. So when the PI is positive and more than 1, it will be undertaken by the company, and shareholders’ wealth will be maximized. This is a very important merit of PI because shareholders’ wealth maximization is the primary goal of all investment strategies.

Following are the demerits of using the Profitability Index Method −

In the case of PI, the ratio of the present value of cash inflows to the initial value of cash outflows gives a relative measure of the profitability calculated by PI. Therefore, it is an insufficient measure of profitability. PI can only assume true profitability as it is related to initial cash outflow and not with all outflows that occur in the future.

Like NPV and IRR, PI also considers cash flows and discount rates which are impossible to estimate accurately. Therefore, although theoretically sound, PI is not far from flaws in practice. As the determination of cash flows in the future cannot be completely accurate, the value of profit measured by PI cannot be free from flaws. The same statement holds good for discount rate calculations.

- Related Questions & Answers
- What are the merits and demerits of a distributed system?
- What is Profitability index in discounted cash flow technique in capital budgeting?
- Difference between Net Present Value (NPV) and Profitability Index (PI)
- What are the document properties of IE4 DOM method?
- What are the method references in Java?
- What does the method elementAt(int index) do in java?
- What does the method removeElementAt(int index) do in java?
- Merits and demerits of using IRR as an investment evaluation method
- Merits and demerits of using NPV as an investment evaluation method
- What are the components of the CPU?
- Python Pandas - Return the label from the index if all of the labels in the index are later than the passed label
- What are the duties of the President of India?
- What is the percentage of the completion method?
- What are the rules on method overriding in Java?
- What are the differences between get() and navigate() method?

Advertisements