What are the merits of the Profitability Index Method?

Banking & FinanceFinance ManagementGrowth & Empowerment

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.

Merits of Profitability Index Method

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

Recognition of Time Value of Money

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.

Value Maximization

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.

Demerits of Profitability Index Method

Following are the demerits of using the Profitability Index Method −

Relative Measure of Profitability

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.

Cash flow and discount rate calculation

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.

raja
Published on 27-Oct-2021 05:36:02
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